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Table of contents :
Cover......Page 1
Title Page......Page 2
Copyright Page......Page 3
About the Authors......Page 4
Contents......Page 7
Preface......Page 11
Acknowledgements......Page 15
Starbucks Coffee......Page 17
The Nature of Accounting......Page 20
The Balance Sheet......Page 24
Balance Sheet Transactions......Page 25
Types of Ownership......Page 32
Accounting Differences Between Proprietorships, Partnerships, and Corporations......Page 34
Stockholders and the Board of Directors......Page 37
Regulation of Financial Reporting......Page 38
The Accounting Profession......Page 40
Career Opportunities for Accountants......Page 43
Highlights to Remember......Page 46
Assignment Material......Page 47
General Mills......Page 59
Introduction to Income Measurement......Page 61
Measuring Income......Page 67
The Income Statement......Page 71
Accounting for Dividends and Retained Earnings......Page 76
Four Popular Financial Ratios......Page 80
The Portfolio......Page 84
Conceptual Framework......Page 90
Other Basic Concepts And Conventions......Page 93
Highlights to Remember......Page 95
Assignment Material......Page 96
Delta Air Lines......Page 111
The Double-Entry Accounting System......Page 113
Debits and Credits......Page 116
The Recording Process......Page 117
Analyzing, Journalizing, and Posting the Biwheels Transactions......Page 120
Biwheels’ Transactions in the Journal and Ledger......Page 127
Preparing the Trial Balance......Page 130
Effects of Errors......Page 137
Incomplete Records......Page 139
Data Processing and Accounting Systems......Page 140
Accounting Vocabulary......Page 142
Assignment Material......Page 143
Columbia Sportswear......Page 161
Adjustments to the Accounts......Page 163
I. Expiration or Consumption of Unexpired Costs......Page 164
II. Earning of Revenues Received in Advance......Page 165
III. Accrual of Unrecorded Expenses......Page 167
IV. Accrual of Unrecorded Revenues......Page 170
The Adjusting Process in Perspective......Page 172
Classified Balance Sheet......Page 177
Income Statement......Page 182
Profitability Evaluation Ratios......Page 186
Highlights to Remember......Page 190
Assignment Material......Page 191
Costco......Page 209
Overview of Statement of Cash Flows......Page 210
Preparing a Statement of Cash Flows......Page 213
Cash Flow from Operating Activities......Page 220
The Statement of Cash Flows and the Balance Sheet Equation......Page 228
Examples of Statements of Cash Flows......Page 230
The Importance of Cash Flow......Page 232
Highlights to Remember......Page 239
Assignment Material......Page 240
Oracle Corporation......Page 259
Recognition of Sales Revenue......Page 260
Measurement of Sales Revenue......Page 263
Credit Sales and Accounts Receivable......Page 269
Measurement of Uncollectible Accounts......Page 270
Assessing the Level of Accounts Receivable......Page 277
Accounting for and Managing Cash......Page 279
Overview of Internal Control......Page 280
Highlights to Remember......Page 284
Appendix 6: Bank Reconciliations......Page 285
Accounting Vocabulary......Page 287
Assignment Material......Page 288
The Home Depot......Page 305
Gross Profit and Cost of Goods Sold......Page 306
Perpetual and Periodic Inventory Systems......Page 307
Cost of Merchandise Acquired......Page 310
Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems......Page 312
Principal Inventory Valuation Methods......Page 314
Lower-of-Cost-or-Market Method......Page 320
Effects of Inventory Errors......Page 322
Cutoff Errors and Inventory Valuation......Page 324
The Importance of Gross Profi ts......Page 325
Internal Control of Inventories......Page 329
Highlights to Remember......Page 331
Appendix 7A: Characteristics and Consequences of LIFO......Page 332
Appendix 7B: Inventory in a Manufacturing Environment......Page 336
Assignment Material......Page 338
Intel Corporation......Page 359
Overview of Long-Lived Assets......Page 361
Contrasting Long-Lived Asset Expenditures with Expenses......Page 363
Acquisition Cost of Tangible Assets......Page 364
Depreciation of Buildings and Equipment......Page 366
Changes in Estimated Useful Life or Residual Value......Page 370
Depreciation and Cash Flow......Page 371
Expenditures after Acquisition......Page 374
Gains and Losses on Sales of Tangible Assets......Page 375
Revaluation of Tangible Assets......Page 379
Intangible Assets......Page 381
Goodwill......Page 385
Highlights to Remember......Page 387
Assignment Material......Page 389
Jack in the Box......Page 407
Liabilities in Perspective......Page 408
Accounting for Current Liabilities......Page 410
Long-Term Liabilities......Page 415
Bond Accounting......Page 420
Accounting for Leases......Page 429
Other Long-Term Liabilities, Including Pensions and Deferred Taxes......Page 434
Debt Ratios and Interest-Coverage Ratios......Page 441
Highlights to Remember......Page 442
Appendix 9: Compound Interest, Future Value, and Present Value......Page 443
Accounting Vocabulary......Page 450
Assignment Material......Page 451
United Parcel Service (UPS)......Page 469
Background on Stockholders’ Equity......Page 472
Accounting For Common Stock in Publicly Held Corporations......Page 473
Preferred Stock......Page 477
Stock Options and Restricted Stock......Page 481
Stock Splits and Stock Dividends......Page 483
Repurchase of Shares......Page 488
Other Issuances of Common Stock......Page 493
Retained Earnings Restrictions......Page 494
Financial Ratios Related to Stockholders’ Equity......Page 495
Highlights to Remember......Page 497
Assignment Material......Page 498
Coca-Cola Company......Page 513
An Overview of Corporate Investments......Page 514
Short-Term Investments......Page 515
Long-Term Investments in Bonds......Page 520
The Market and Equity Methods for Intercorporate Equity Investments......Page 522
Consolidated Financial Statements......Page 525
Purchase Price not Equal to Book Value......Page 536
Summary of Accounting for Equity Securities......Page 537
Highlights to Remember......Page 538
Accounting Vocabulary......Page 539
Assignment Material......Page 540
Nike......Page 553
Sources of Information About Companies......Page 555
Objectives of Financial Statement Analysis......Page 556
Evaluating Trends and Components of the Business......Page 558
Financial Ratios......Page 569
Operating Performance and Financing Decisions......Page 576
Prominence of Earnings Per Share......Page 582
Disclosure of Irregular Items......Page 584
Valuation Issues......Page 588
Relating Cash Flow and Net Income......Page 591
Highlights to Remember......Page 595
Assignment Material......Page 596
B......Page 620
C......Page 621
D......Page 622
F......Page 623
I......Page 624
M......Page 625
P......Page 626
R......Page 627
S......Page 628
Z......Page 629
A......Page 630
B......Page 631
C......Page 632
D......Page 633
F......Page 634
I......Page 635
M......Page 637
P......Page 638
R......Page 639
S......Page 640
U......Page 641
B......Page 642
F......Page 643
M......Page 644
S......Page 645
Z......Page 646
Photo Credits......Page 648
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Eleventh Edition

I ntro d u c t i o n t o

Financial Accounting Charles T. Horngren Stanford University

Gary L. Sundem University of Washington

John A. Elliott University of Connecticut

Donna R. Philbrick Portland State University

Boston  Columbus  Indianapolis  New York  San Francisco  Upper Saddle River   Amsterdam  Cape Town  Dubai  London  Madrid  Milan  Munich  Paris  Montréal  Toronto   Delhi  Mexico City  São Paulo  Sydney  Hong Kong  Seoul  Singapore  Taipei  Tokyo

To Chuck Horngren whose contributions over many years have made this textbook what it is.

Editor in Chief: Donna Battista Acquisitions Editor: Lacey Vitetta Director of Editorial Services: Ashley Santora Senior Editorial Project Manager: Karen Kirincich Marketing Manager: Alison Haskins Marketing Assistant: Kimberly Lovato Senior Production Project Manager: Roberta Sherman

Manufacturing Buyer: Carol Melville Art Director: Anthony Gemmellaro Interior Design: Lisa Delgado/Emily Friel, Integra Cover Design: Anthony Gemmellaro Cover Photos: Ryan McVay/Stone/Getty Images; Mary Rice/Shutterstock Art Studio: GEX Publishing Services Compositor: GEX Publishing Services

Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text (or on page PC1). Copyright © 2014 by Pearson Education, Inc. All rights reserved. Manufactured in the United States of America. This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise. To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290. Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks. Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps. Library of Congress Cataloging-in-Publication Data Horngren, Charles T.   Introduction to inancial accounting / Charles T. Horngren, Gary L. Sundem, John A. Elliott, Donna R. Philbrick. -- Eleventh edition.       pages cm   Includes index.   ISBN 978-0-13-325103-6 (casebound) 1.  Accounting. I. Title.   HF5635.H813 2014   657--dc23                                                            2012047453

10  9  8  7  6  5  4  3  2  1 ISBN-13: 978-0-13-325103-6 ISBN-10: 0-13-325103-9

About the Authors Charles T. Horngren passed away in the midst of this current revision of Introduction to Financial Accounting. He was the Edmund W. Littlefield professor of accounting emeritus at Stanford University. A graduate of Marquette University, he received his MBA from Harvard University and his PhD from the University of Chicago. He also received honorary doctorates from Marquette University and DePaul University. A certified public accountant, Horngren served on the Accounting Principles Board, the Financial Accounting Standards Board Advisory Council, and the Council of the American Institute of Certified Public Accountants. In addition, he served as a trustee of the Financial Accounting Foundation, which oversees the Financial Accounting Standards Board and the Government Accounting Standards Board. He is a member of the Accounting Hall of Fame. Horngren served the American Accounting Association as its president and its director of research. He received the association’s first annual Outstanding Accounting Educator Award and also received its Lifetime Contribution to Management Accounting Award. The California Certified Public Accountants Foundation gave Horngren its Faculty Excellence Award and its Distinguished Professor Award. He is the first person to have received both awards. The American Institute of Certified Public Accountants presented him with its first Outstanding Educator Award. He was also named Accountant of the Year, Education, by the national professional accounting fraternity, Beta Alpha Psi. Professor Horngren was also a member of the Institute of Management Accountants, where he received its Distinguished Service Award. He was a member of the Institute’s Board of Regents, which administers the Certified Management Accountant examinations. Horngren is the author of other accounting books published by Pearson Education: Cost Accounting: A Managerial Emphasis, Introduction to Management Accounting, Accounting, and Financial Accounting. He was also the Consulting Editor for the Charles T. Horngren Series in Accounting.

Gary L. Sundem is professor of accounting emeritus at the Foster School of Business at the University of Washington, Seattle. He received his BA from Carleton College and his MBA and PhD from Stanford University. Professor Sundem has served as President of the American Accounting Association, Executive Director of the Accounting Education Change Commission, and Editor of The Accounting Review. He is currently president of the International Association for Accounting Education and Research. Sundem is a past president of the Seattle chapter of the IMA (formerly the Institute of Management Accountants). He has served on IMA’s national board of directors and chaired its Academic Relations and Professional Development committees. He has chaired the AACSB’s Accounting Accreditation Committee and currently serves on the Board of Trustees of Rainier Mutual Funds and the Board of Trustees of Carleton College, where he chairs the Audit Committee. He received the Carleton College Outstanding Alumni award in 2002. Professor Sundem has numerous publications in accounting and finance journals including Issues in Accounting Education, The Accounting Review, Journal of Accounting Research, and Journal of Finance. He was selected as the Outstanding Accounting Educator by the American Accounting Association in 1998 and by the Washington Society of CPAs in 1987.

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John A. Elliott is the dean of the School of Business at the University of Connecticut and the Auran J. Fox Chair in Business. Prior to joining the University of Connecticut, he served for 10 years as dean of the Zicklin School of Business at Baruch College, part of the City University of New York (CUNY). He was the Irwin and Arlene Ettinger professor of accountancy. He received his BS and MBA from the University of Maryland and his PhD from Cornell University. Prior to accepting the deanship at the Zicklin School, he spent 20 years on the faculty at Cornell University’s Johnson Graduate School of Management, most recently as associate dean for academic affairs. Dean Elliott is a certified public accountant with professional experience as an auditor and consultant for Arthur Andersen & Co. and in the controller’s office of the Westinghouse Defense and Space Center. During his career he has taught at seven different institutions. His responsibilities have included financial accounting, intermediate accounting, financial statement analysis, taxation, and extensive executive teaching. In 2004 his paper on earnings management (with Nelson and Tarpley) received the award from the American Accounting Association for Notable Contributions to Accounting Literature. His research is concentrated on the role of accounting information in financial analysis and contracts. He serves on two corporate boards, NFP and Liquidnet, and chairs their audit committees. He has previously served on and chaired the boards for the Hangar Theatre, Cayuga Medical Center, and the Graduate Management Admissions Council. Donna R. Philbrick is Professor of Accounting at Portland State University. She received her BS from the University of Oregon and her MBA and PhD from Cornell University. Professor Philbrick is a certified public accountant (inactive) and worked as an auditor for Touche Ross (now Deloitte & Touche) and Price Waterhouse (now PricewaterhouseCoopers) prior to returning for her graduate degrees. Before joining the faculty at Portland State University, she taught at the University of Oregon and Duke University. She currently teaches at both the graduate and undergraduate levels, focusing on financial accounting, intermediate accounting, and financial statement analysis. Professor Philbrick has taught for many years in the Oregon Executive MBA program and has experience teaching in numerous corporate programs. Professor Philbrick’s research has been published in accounting journals including The Accounting Review, Journal of Accounting Research, and Journal of Accounting and Economics. Most recently her research has focused on corporate governance issues. She has served on the Advisory Board and as an associate editor of Accounting Horizons.

iv

Brief Contents Preface xiv Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12

Accounting: The Language of Business 2 Measuring Income to Assess Performance 44 The Portfolio P1 Recording Transactions 90 Accrual Accounting and Financial Statements 140 Statement of Cash Flows 188 Accounting for Sales 238 Inventories and Cost of Goods Sold 284 Long-Lived Assets 338 Liabilities and Interest 386 Stockholders’ Equity 448 Intercorporate Investments and Consolidations 492 Financial Statement Analysis 532

Glossary G1 Index I1 Photo Credits PC1

v

Contents Preface xiv Acknowledgements xvi

Chapter 1

Accounting: The Language of Business 2 Starbucks Coffee 2

The Nature of Accounting 5 The Balance Sheet 9 Balance Sheet Transactions 10 Types of Ownership 17 Accounting Differences Between Proprietorships, Partnerships, and Corporations 19 Stockholders and the Board of Directors 22 Regulation of Financial Reporting 23 Credibility and the Role of Auditing 25 The Accounting Profession 25 Career Opportunities for Accountants 28 Highlights to Remember 31 Assignment Material 32

Chapter 2

• Accounting Vocabulary

32



Measuring Income to Assess Performance 44 General Mills

44

Introduction to Income Measurement 46 Measuring Income 52 The Income Statement 56 Accounting for Dividends and Retained Earnings 61 Four Popular Financial Ratios 65 The Portfolio P1 Conceptual Framework 69 Other Basic Concepts And Conventions 72 Highlights to Remember 74 Assignment Material 75

Chapter 3

• Accounting Vocabulary

75



Recording Transactions 90 Delta Air Lines 90

The Double-Entry Accounting System 92 Debits and Credits 95 The Recording Process 96 Analyzing, Journalizing, and Posting the Biwheels Transactions 99 Biwheels’ Transactions in the Journal and Ledger 106 Preparing the Trial Balance 109 Effects of Errors 116 Incomplete Records 118 Data Processing and Accounting Systems 119 Highlights to Remember 121 Assignment Material 122 vi

• Accounting Vocabulary

121



Chapter 4

Accrual Accounting and Financial Statements 140 Columbia Sportswear 140

Adjustments to the Accounts 142 I. Expiration or Consumption of Unexpired Costs 143 II. Earning of Revenues Received in Advance 144 III. Accrual of Unrecorded Expenses 146 IV. Accrual of Unrecorded Revenues 149 The Adjusting Process in Perspective 151 Classiied Balance Sheet 156 Income Statement 161 Proitability Evaluation Ratios 165 Highlights to Remember 169 Assignment Material 170

Chapter 5

• Accounting Vocabulary

170



Statement of Cash Flows 188 Costco

188

Overview of Statement of Cash Flows 189 Preparing a Statement of Cash Flows 192 Cash Flow from Operating Activities 199 The Statement of Cash Flows and the Balance Sheet Equation 207 Examples of Statements of Cash Flows 209 The Importance of Cash Flow 211 Highlights to Remember 218 Assignment Material 219

Chapter 6

• Accounting Vocabulary

219



Accounting for Sales 238 Oracle Corporation 238

Recognition of Sales Revenue 239 Measurement of Sales Revenue 242 Credit Sales and Accounts Receivable 248 Measurement of Uncollectible Accounts 249 Assessing the Level of Accounts Receivable 256 Accounting for and Managing Cash 258 Overview of Internal Control 259 Highlights to Remember 263 • Appendix 6: Bank Reconciliations Accounting Vocabulary 266 • Assignment Material 267

Chapter 7

264



Inventories and Cost of Goods Sold 284 The Home Depot 284

Gross Proit and Cost of Goods Sold 285 Perpetual and Periodic Inventory Systems 286 Cost of Merchandise Acquired 289 Comparing Accounting Procedures for Periodic and Perpetual Inventory Systems 291 Principal Inventory Valuation Methods 293 Lower-of-Cost-or-Market Method 299 Effects of Inventory Errors 301 vii

Cutoff Errors and Inventory Valuation 303 The Importance of Gross Proits 304 Gross Proit Percentages And Accuracy of Records 308 Internal Control of Inventories 308 Highlights to Remember 310 • Appendix 7A: Characteristics and Consequences of LIFO 311 • Appendix 7B: Inventory in a Manufacturing Environment 315 • Accounting Vocabulary 317 • Assignment Material 317

Chapter 8

Long-Lived Assets 338 Intel Corporation 338

Overview of Long-Lived Assets 340 Contrasting Long-Lived Asset Expenditures with Expenses 342 Acquisition Cost of Tangible Assets 343 Accounting Alternatives Subsequent to Acquisition 345 Depreciation of Buildings and Equipment 345 Changes in Estimated Useful Life or Residual Value 349 Contrasting Income Tax and Shareholder Reporting 350 Depreciation and Cash Flow 350 Expenditures after Acquisition 353 Gains and Losses on Sales of Tangible Assets 354 Revaluation of Tangible Assets 358 Intangible Assets 360 Goodwill 364 Depletion of Natural Resources 366 Highlights to Remember 366 Assignment Material 368

Chapter 9

• Accounting Vocabulary

368



Liabilities and Interest 386 Jack in the Box 386

Liabilities in Perspective 387 Accounting for Current Liabilities 389 Long-Term Liabilities 394 Bond Accounting 399 Accounting for Leases 408 Other Long-Term Liabilities, Including Pensions and Deferred Taxes 413 Debt Ratios and Interest-Coverage Ratios 420 Highlights to Remember 421 • Appendix 9: Compound Interest, Future Value, and Present Value 422 • Accounting Vocabulary 429 • Assignment Material 430

Chapter 10

Stockholders’ Equity 448 United Parcel Service (UPS) 448

Background on Stockholders’ Equity 451 Accounting For Common Stock in Publicly Held Corporations 452 Preferred Stock 456 Stock Options and Restricted Stock 460 Stock Splits and Stock Dividends 462 Repurchase of Shares 467

viii

Other Issuances of Common Stock 472 Retained Earnings Restrictions 473 Other Components of Stockholders’ Equity 474 Financial Ratios Related to Stockholders’ Equity 474 Highlights to Remember 476 Assignment Material 477

Chapter 11

• Accounting Vocabulary

477



Intercorporate Investments and Consolidations 492 Coca-Cola Company 492

An Overview of Corporate Investments 493 Short-Term Investments 494 Long-Term Investments in Bonds 499 The Market and Equity Methods for Intercorporate Equity Investments 501 Consolidated Financial Statements 504 Purchase Price not Equal to Book Value 515 Summary of Accounting for Equity Securities 516 Highlights to Remember 517 Assignment Material 519

Chapter 12

• Accounting Vocabulary

518



Financial Statement Analysis 532 Nike

532

Sources of Information About Companies 534 Objectives of Financial Statement Analysis 535 Evaluating Trends and Components of the Business 537 Financial Ratios 548 Operating Performance and Financing Decisions 555 Prominence of Earnings Per Share 561 Disclosure of Irregular Items 563 International Issues 567 Valuation Issues 567 Relating Cash Flow and Net Income 570 Highlights to Remember 574 Assignment Material 575

• Accounting Vocabulary

575



Glossary G1 Index I1 Photo Credits PC1

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Preface “You have to know what something is before you know how to use it.” Introduction to Financial Accounting, 11/E, describes the most widely accepted accounting theory and practice with an emphasis on using and analyzing the information in inancial statements. It compares U.S. generally accepted accounting principles (U.S. GAAP) to International Financial Reporting Standards (IFRS) where appropriate. IFA, 11/E, takes the view that business is an exciting process and that accounting is the perfect window through which to see how economic events affect businesses. Because we believe that accounting aids the understanding of economic events and that accounting builds on simple principles, this book introduces a number of concepts earlier than many other textbooks. We cover these early concepts at the most accessible level and illustrate them with carefully chosen examples from real companies. Our coverage addresses the choices that management makes when preparing financial statements and how these choices affect the way users interpret the information. We also discuss ethical issues throughout the book and in the assignment materials. This is the eleventh edition of this text, and that is a testimonial to its effectiveness. But it also is a testimonial to our former colleagues, students, and adopters who, in each prior edition, have shared their thoughts and suggestions and driven us to change and adapt it to better meet the needs of today’s students and adopting faculty. Continuing strengths of this edition: 䊉 䊉 䊉 䊉

Text coverage and problem material based on classic issues arising in the last 30 years Integration of ethics coverage throughout Coverage of U.S. GAAP and IFRS requirements where material differences exist Use of international-company examples, especially to illustrate differences in U.S. GAAP and IFRS New to this edition:

䊉 䊉 䊉

䊉 䊉



Totally updated text to include current examples from real companies Extensive revisions for clarity Revision of problem material to include examples from corporate outcomes in the last two years Coverage of the current status of FASB and IASB regulatory action Highlights of likely upcoming changes in accounting standards, including revenue recognition and leases Updated Business First Boxes

Our Philosophy Introduce the simple concepts early, revisit concepts at more complex levels as students gain understanding, and provide appropriate real-company examples at every stage— that’s our philosophy. Our goal is for students to be able to read and interpret a real company’s financial statements: balance sheet, income statement, statement of cash flows, and statement of changes in stockholders’ equity. We want students to view accounting as a tool that enhances their understanding of economic events. Students should be asking questions such as “After this transaction, are we better or worse off?” and “What do these statements tell us about the company’s financial position and performance?” Students cannot understand financial statements in isolation. Rather, they must look at all the financial statements within the context of the company’s business environment. They need to x

understand the accrual basis of accounting that underlies the balance sheet and income statement, but they must also understand the importance of cash as presented in the statement of cash flows. We present the balance sheet, income statement, statement of changes in stockholders’ equity, and statement of cash flows in the first five chapters. By presenting the statement of cash flows in Chapter 5, immediately after the presentation of the basics of accrual accounting, students learn the importance of all the statements and the unique information each statement presents before encountering details about financial reporting practices in the later chapters. One of our former colleagues often focuses on an economic event by asking, “Are you happy or are you sad?” We believe that accounting provides a way to understand what is happening and to answer that question. You might think of the basic financial statements as scorecards in the most fundamental economic contests. Each year the financial statements help you answer the most important questions: Are you happy or sad? Did you make or lose money? Are you prospering or just surviving? Will you have the cash you need for the next big step?

Who Should Use This Book? Introduction to Financial Accounting, 11/E, presupposes no prior knowledge of accounting and is suitable for any undergraduate or MBA student enrolled in a inancial accounting course. It is also appropriate for management education programs where the participants have little or no accounting background. It deals with important topics that all managers should know and all business students should study. We have aimed to present relevant subject matter and to present it clearly and accessibly. This text is oriented to the user of financial statements but gives ample attention to the needs of potential accounting practitioners. IFA, 11/E, stresses underlying concepts yet makes them concrete with numerous illustrations, many taken from recent corporate annual reports. Moreover, accounting procedures such as transaction analysis, journalizing, and posting are given due consideration where appropriate. Managers and accountants can develop a better understanding of the economic consequences of a company’s transactions by summarizing those transactions into journal entries and T-accounts. However, the ultimate objective is an understanding of financial position and prospects, which we achieve by a focus on the balance sheet equation.

Coverage of IFRS 䊉



We cover critical differences between U.S. generally accepted accounting principles (U.S. GAAP) and International Financial Reporting Standards (IFRS) without unnecessary details. We include problem materials from companies reporting under IFRS as well as U.S. GAAP.

Emphasis on Understanding and Analyzing Financial Statements 䊉



Financial Statement Portfolio, inserted in Chapter 2 and identified by a blue vertical bar on the page edges, provides a visual roadmap to financial statement analysis by highlighting key financial ratios and how to derive them from the financial statements. The Financial Statement Portfolio also refers students to appropriate chapters in the book for in-depth coverage of these ratios. It is included in Chapter 2 to focus students on the uses of accounting information early in the course. Interpreting Financial Statements sections within each chapter permit students to pause and ponder how to use the information they are learning to better understand the financial position and prospects of a company.

xi





Analyzing and Interpreting Financial Statements problems at the end of each chapter include financial statement research, analyses of Starbucks financial statements, and analysis of other companies’ financial statements using the Internet. Focus on Starbucks’ Annual Report is used to illustrate various methods for analyzing financial statements. There is a problem based on Starbucks in each chapter, allowing students to get a more complete picture of many financial reporting issues relating to one particular company.

Other Features 䊉





Extensive treatment of ethics, with both text coverage and end-of-chapter problems focusing on this important topic in nearly every chapter. Critical Thinking Exercises in the assignment material of each chapter that ask students to consider conceptual issues that may have no right answer. Business First Boxes in each chapter, many new or completely revised. These boxes provide insights into operations at well-known domestic and international companies, accenting today’s real-world issues.

Teaching and Learning Support: Because Resources Should Simplify, Not Overwhelm: A successful accounting course requires more than a well-written book. Today’s classroom requires a dedicated teacher and a fully integrated teaching package. The following material supports this title.

Student Resources www.myaccountinglab.com MyAccountingLab is Web-based tutorial and assessment software for accounting that gives students more “I get it!” moments. MyAccountingLab provides students with a personalized interactive learning environment where they can complete their course assignments with immediate tutorial assistance, learn at their own pace, and measure their progress. In addition to completing assignments and reviewing tutorial help, students have access to the following resources in MyAccountingLab: 䊉 䊉 䊉 䊉

Flash-based eText Study Guide Excel Templates PowerPoints

Student Resource Website www.pearsonhighered.com/horngren 䊉

Excel Templates

Instructor Resources www.myaccountinglab.com MyAccountingLab provides instructors the lexibility to make technology an integral part of their course. And, because practice makes perfect, MyAccountingLab offers exactly the same end-of-chapter material found in the text with algorithmic options that instructors can assign for homework. MyAccountingLab also replicates the text’s exercises and problems with journal entries and inancial statements so that students are familiar and comfortable working with the material.

xii

Solutions Manual The Solutions Manual, written by the text authors, is available electronically. It contains the fully worked-through and accuracy-checked solutions for every question, exercise, and problem in the text. Special thanks to Carolyn Streuly for reviewing this material.

Instructor Resource Center www.pearsonhighered.com/horngren For your convenience, many of our instructor supplements are available for download from the textbook’s catalog page or your MyAccountingLab account. Available resources include the following: 䊉







䊉 䊉 䊉

Test Item File: The Test Item File includes multiple choice, true/false, exercises, comprehensive problems, short answer problems, critical thinking essay questions, and so on. Each test item is tied to the corresponding learning objective and has an assigned difficulty level. TestGen: This PC/MAC-compatible test generating software is powerful and easy to use. It is preloaded with all the questions from the new Test Item File and allows users to manually or randomly view test bank questions and drag and drop them to create a test. Add or modify questions using the built-in Question Editor, print up to 25 variations of a single test, and create and export tests that are compatible with commonly used course management systems. Instructor’s Resource Manual: This manual contains the following elements for each chapter of the text: chapter overviews, chapter outlines organized by objectives, teaching tips, chapter quiz. PowerPoint Slides: Comprehensive slides designed to aid in presentation of key chapter concepts Excel Templates and Solutions Solutions Manual Image Library

Technical support is available at http://247pearsoned.custhelp.com.

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Acknowledgements Our appreciation extends to our present and former mentors, colleagues, and students. This book and our enthusiasm for accounting grew out of their collective contributions to our knowledge and experience. A special thanks to Norbert Tschakert, University of the Virgin Islands, for his suggestions on IFRS. Thank you to the following people who provided valuable contributions on the supplements: Carolyn Streuly; Sheila Handy, East Stroudsburg University; and Victoria Kaskey, Ashland University. We would also like to thank those who gave valuable feedback on previous editions: John E. Armstrong, Dominican College; Frances L. Ayers, University of Oklahoma; Karthik Balakrishnan, The Wharton School; Roderick S. Barclay, University of Texas at Dallas; Ronald S. Barden, Georgia State University; Mary Barth, Stanford University; Paul E. Bayes, East Tennessee State University; Martin J. Birr, Indiana University; Robert Bowen, University of San Diego; Marianne Bradford, The University of Tennessee; Nancy Cassidy, Texas A&M University; David T. Collins, Bellarmine College; Michele J. Daley, Rice University; Ray D. Dillon, Georgia State University; Patricia A. Doherty, Boston University; Philip D. Drake, Thunderbird, The American Graduate School of International Management; Allan R. Drebin, Northwestern University; Roland “Pete” Dukes, University of Washington; Robert Dunn, Georgia Institute of Technology; Thomas R. Dyckman, Cornell University; Alan H. Falcon, Loyola Marymount University; Anita Feller, University of Illinois; Catherine Finger-Podolsky, Saint Mary’s College of California; Richard Frankel, University of Michigan; John D. Gould, Western Carolina University; D. Jacque Grinnell, University of Vermont; Leon J. Hanouille, Syracuse University; Al Hartgraves, Emory University; Suzanne Hartley, Franklin University; Robert E. Holtfreter, Central Washington University; Peter Huey, Collin County Community College; Yuji Ijiri, Carnegie Mellon University; M. Zafar Iqbal, California Polytechnic State University–San Luis Obispo; Jane Jollineau, University of San Diego; Gregory D. Kane, University of Delaware; Urooj Khan, Columbia Business School; Sungsoo Kim, Rutgers University; April Klein, New York University; Robert Libby, Cornell University; Joan Luft, Michigan State University; Maureen McNichols, Stanford University; Mark J. Myring, Ball State University; Brian M. Nagle, Duquesne University; John L. Norman Jr., Keller Graduate School of Management; Mohamed Onsi, Syracuse University; David M. Perkal, NYU– Stern School of Business; Elizabeth Plummer, Southern Methodist University; Patrick M. Premo, St. Bonaventure University; Renee A. Price, University of Nebraska; Leo A. Ruggle, Mankato State University; James A. Schweikart, Rhode Island College; Chandra Seethamraju, Washington University–St. Louis; Bill Shoemaker, University of Dallas; William Smith, Xavier University; Robert Swieringa, Cornell University; Daniel Taylor, University of Pennsylvania– The Wharton School; Katherene P. Terrell, University of Central Oklahoma; Michael G. Vasilou, DeVry Institute of Technology–Chicago; Deborah Welch, Tyler Junior College; William Wells, University of Washington; Christine Wiedman, University of Western Ontario; Patrick T. Wirtz, University of Detroit Mercy; and Peter D. Woodlock, Youngstown State University. Finally, we’d like to thank the following people at Pearson Education: Lacey Vitetta, Donna Battista, Ashley Santora, Karen Kirincich, Roberta Sherman, and Jeff Holcomb. Comments from users are welcome. Charles T. Horngren Gary L. Sundem John A. Elliott Donna R. Philbrick

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I n t ro d u c t i o n t o

Financial Accounting

1

Accounting: The Language of Business ACCOUNTING IS THE LANGUAGE OF business. It is the method companies use to communicate financial information to their employees and to the public. Until recently, the accounting language, like spoken languages, differed country to country. Today only two main accounting languages have survived, one used in the United States and another used in Europe and most of the rest of the world. These are actually more like dialects of a single language because they are identical in most respects and are gradually converging into a single language. In this text we focus on the U.S. perspective but discuss the significant differences between the languages when they arise. We also use real companies to illustrate the language of accounting in practice. Consider Starbucks Corporation, a U.S.-based company that uses the accounting language employed by all U.S. companies. You have probably purchased a latte in, or at least walked by, one of Starbucks’ 18,000 coffee stores throughout the world. Did you know that you could also buy a share of Starbucks stock, making you a part owner of Starbucks? When you buy a latte, you want to know how it tastes. When you buy a share of stock, you want to know about the financial condition and prospects of Starbucks Corporation. You would want to own part of Starbucks only if you think it will be successful in the future. To learn this, you need to understand the accounting language used in Starbucks’ financial reports. By the time you finish reading this book, you will be comfortable reading the financial reports of Starbucks and other companies and be able to use those reports to assess the financial health of these companies. Starbucks was founded in 1985 and first issued shares of stock to the public in 1992. If you had purchased shares at that time, as of this writing your investment would be worth more than $60 for every $1 you invested. Will Starbucks be a good investment in the future? No one can predict with certainty Starbucks’ financial prospects. However, the company’s financial statements, which are available on Starbucks’ Web site, can give you clues. But you need to understand accounting to make sense of this financial information.

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain how accounting information assists in making decisions. 2 Describe the components of the balance sheet. 3 Analyze business transactions and relate them to changes in the balance sheet. 4 Prepare a balance sheet from transactions data.

5 Compare the features of sole proprietorships, partnerships, and corporations. 6 Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or a partnership. 7 Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.

8 Describe auditing and how it enhances the value of financial information. 9 Evaluate the role of ethics in the accounting process. 10 Recognize career opportunities in accounting, and understand that accounting is important to both for-profit and nonprofit organizations.

Starbucks has established a worldwide reputation in a short time. It was #16 on Fortune magazine’s list of Most Admired Companies in 2011. It has consistently been included among the Top 5 Global Brands of the Year as identified by Brandchannel.com’s Readers’ Choice survey and ranked among CR Magazine’s 100 Best Corporate Citizens in 2011 for the 12th year in a row, one of only three companies to make the list all 12 years. It has also been on Ethisphere’s list of the world’s most ethical companies every year since the list started in 2007. Despite all these awards, potential investors want to know something about Starbucks’ financial prospects. Let’s look at a few financial facts. As you proceed through this book, you will develop a better understanding of how to interpret these facts.

Starbucks has more than 18,000 coffee shops throughout the world. Although a majority (71%) are in the Americas, fully 18% are in the China/Asia Pacific region.

In 2011, Starbucks reported total revenues—the amount the company received for all the items sold—of $11.7 billion, compared with only $700 million in 1996. Net income—the profit that Starbucks made—was $1,246 million, up from $42 million in 1996 and $946 million in 2010. Total assets—the recorded value of the items owned by Starbucks—grew from less than $900 million to almost $7.4 billion from 1996 to 2011. You can see that the amount of business done by Starbucks has grown quickly. However, there is much more to be learned from the details in Starbucks’ financial statements. You will learn about revenues, income, assets, and other elements of accounting as you read this book.



As we embark on our journey into the world of accounting, we explore how a company such as Starbucks reports on its financial activities and how investors use this accounting information to better understand Starbucks. Keep this in mind: The same basic accounting framework that supported a small coffee company like Starbucks in 1985 supports the larger company today, and indeed it supports businesses (big and small, old and new) worldwide. Accounting is a process of identifying, recording, and summarizing economic information and reporting it to decision makers. You are correct if you expect to learn a set of rules and procedures about how to record and report financial information. However,

accounting The process of identifying, recording, and summarizing economic information and reporting it to decision makers.

3

4

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

understanding accounting reports goes beyond rules and procedures. To use your financial accounting education effectively, you must also understand the underlying business transactions that give rise to the economic information and why the information is helpful in making financial decisions. We hope that you want to know how businesses work. When you understand that Starbucks’ financial reports help its management make decisions about producing and selling products, as well as helping investors assess the performance and prospects of Starbucks, you will see why being able to read and interpret these reports is important. Both outside investors and internal managers need this information. Our goal is to help you understand business transactions—to know how accounting information describes such transactions and how decision makers both inside the company (managers) and outside the company (investors) use that information in deciding how, when, and what to buy or sell. In the process, you will learn about some of the world’s premier companies. You may wonder what it costs to open a new Starbucks store. Are new stores worth such a major investment? How many people visit each Starbucks store every year? Can Starbucks keep track of them all, and are there enough customers to make the stores profitable? If investors consider purchasing Starbucks stock, what do they need to know to decide whether the current price is a reasonable one? Accounting information cannot completely answer every such question, but it provides important insights into many of them. To illustrate how to use accounting information, we will often explore issues that arise in real companies. In pursuing actual business examples, we consider details about many of the 30 companies in the Dow Jones Industrial Average (the DJIA), the most commonly reported stock market index in the world. Well-known companies, such as Coca-Cola, Microsoft, and McDonald’s, are among these 30 companies, along with many other large but less familiar companies, such as Alcoa, The Travelers Companies, and United Technologies Corporation. Exhibit  1-1 lists the 30 Dow companies together with their ticker symbol—the common shorthand used by stockbrokers and investors to identify these companies. The Business First box on page 5 describes the DJIA. We also consider younger and faster-growing companies such as Starbucks, Amazon.com, Apple, and Google and international companies such as Toyota, Nokia, Nestlé, and Volkswagen to illustrate various accounting issues and practices. For now, we start with the basics, most of which are the same regardless of the accounting language a company uses. EXHIBIT 1-1 Dow Industrials Listed by Year Added to the Index Company General Electric ExxonMobil Procter & Gamble DuPont United Technologies Corporation Alcoa 3M IBM Merck American Express McDonald’s Boeing Coca-Cola Caterpillar JPMorgan Chase

Symbol

Year Added

GE XOM PG DD UTX AA MMM IBM MRK AXP MCD BA KO CAT JPM

1907 1928 1932 1935 1939 1959 1976 1979 1979 1982 1985 1987 1987 1991 1991

Company Walt Disney Hewlett-Packard Johnson & Johnson Wal-Mart AT&T Home Depot Intel Microsoft Pfizer Verizon Communications Bank of America Chevron Corporation Cisco Systems The Travelers Companies UnitedHealth Group

Symbol

Year Added

DIS HPQ JNJ WMT T HD INTC MSFT PFE VZ BAC CVX CSCO TRV UNH

1991 1997 1997 1997 1999 1999 1999 1999 2004 2004 2008 2008 2009 2009 2012

THE NATURE OF ACCOUNTING

BUSINESS FIRST T H E D O W J O N E S I N D U S T R I A L AV E R A G E Why did the Dow Jones Industrial Average (DJIA) fall from over 14,000 in late 2007 to under 7,000 in 2009? Why did it rebound to over 13,000 by early 2012? What does this mean to investors? To explain this 50% drop followed by an 86% gain, you need to understand the  DJIA. However, to fully understand the reasons for the drop and gain, you need to understand accounting—what the financial reports prepared by companies really tell you about their financial results and outlook. The DJIA is one of many indices used to describe the performance of stock markets around the world. All indices provide a picture of what is happening on average to the value of securities owned by investors. The Dow began as the average value of an investment in one share of each of 12 stocks and was first published in 1896 by Charles Dow. To calculate it, he simply added the prices of the 12 stocks and divided by 12. It began at 40.94 but fell to an all-time low of 28.48 in August of that year. The calculation today is more complex, but the basic concept is unchanged. Since 1928, the number of stocks in the DJIA has been constant at 30, but there have been 41 changes in the composition of the average. These changes reflect the dynamic nature of American industry. The original DJIA had several auto and petroleum companies to capture the massive importance of these industries. Among the original 12 companies were U.S. Leather, U.S. Rubber, American Tobacco, Tennessee Coal & Iron, and Laclede Gas. Of these, only Laclede Gas, a Missouri utility, still exists—although it is not included in the Dow. Today, only General Electric remains from the original 12, and it was dropped from the index briefly in the early 1900s and reinstated in 1907. Just since 2004 there have been nine changes in the Dow. Pfizer, Verizon, and AIG replaced Eastman Kodak, AT&T, and International Paper in 2004; AT&T returned in 2005 because of its merger with SBC, which had been added in 1999; Bank of America, Chevron Corporation, and Kraft Foods replaced Altria Group, Honeywell, and AIG in 2008; and Cisco Systems and The Travelers Companies replaced Citicorp and General Motors in 2009. It is also interest-

ing to note that the largest one-day Dow increase, 15%, was in October 1931. The largest drop was October 19, 1987, when the Dow fell 23%. Although indices such as the DJIA give a picture of how stock prices have changed, they do not explain why those changes occurred. There is clear evidence that accounting results affect stock prices. Therefore, most financial analysts rely on companies’ financial reports, along with other information, to explain movements in stock prices. For example, BusinessWorld focused on corporate earnings in a recent report: “Demand for a stock moves on the basis of changes in the market’s perception of a stock’s future earnings.” Annual and quarterly financial reports provide much of the information investors use. They use this financial information to predict future financial positions and prospects of companies. In this way, they try to anticipate movements in stock prices. The classic advice to investors is to “buy low and sell high.” Although this is never easy, accounting information can help investors approach this ideal. The DJIA falls when the economy weakens and companies’ profits decline. It rebounds when companies’ financial reports indicate that financial results are on the upswing. The DJIA is not the only index that provides information on the general direction of movements in stock prices. In the United States, Standard and Poor’s publishes the S&P 500, an index of 500 large companies traded in the United States, and NASDAQ publishes an index that tracks many smaller and high-tech firms. Similarly, in the international arena you will often see references to the FTSE, an index of UK companies listed on the London Stock Exchange, and the Nikkei, the most widely quoted index of stocks traded on the Tokyo Stock Exchange. Both are indices of general share-price movements in those markets. Investors worldwide closely follow all of these indices. Sources: D. Somera, “Forces That Move Stock Prices,” BusinessWorld, January 12, 2009, p. S4/2; Dow Jones Indexes (http://djaverages.com); Nikkei index (http://e.nikkei.com; FTSE index (http://www.ftse.com).

The Nature of Accounting Accounting organizes and summarizes economic information so decision makers can use it. Accountants present this information in reports called financial statements. To prepare these statements, accountants analyze, record, quantify, accumulate, summarize, classify, report, and interpret economic events and their financial effects on an organization.

5

6

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

accounting system The series of steps an organization uses to record financial data and convert them into informative financial statements.

 OBJECTIVE 1 Explain how accounting information assists in making decisions.

An organization’s accounting system is the series of steps it uses to record financial data and convert them into informative financial statements. Accountants analyze the information used by managers and other decision makers and create the accounting system that best meets their needs. Bookkeepers and computers then perform the routine tasks of collecting and compiling economic data. The real value of any accounting system lies in the information it provides to decision makers. Consider a university’s accounting system. It collects information about tuition charges and payments and tracks the status of each student. The university must be able to bill individuals with unpaid balances. It must be able to schedule courses and hire faculty to meet the course demands of students. It must ensure that tuition and other cash inflows are sufficient to pay the faculty and keep the buildings warm (or cool) and well lit. In the past, students often became frustrated with university accounting systems. Perhaps there were too many waiting lines at registration or too many complicated procedures in filing for financial aid. However, modern systems allow electronic registration for courses and electronic payments of tuition. The right information system can streamline your life. Every business maintains an accounting system, from the store where you bought this book to the company that issued the credit card you used. MasterCard, Visa, and American Express maintain fast, complicated accounting systems. At any moment, thousands of credit card transactions occur around the globe, and accounting systems keep track of them all. When you use your charge card, a scanner reads it electronically and transmits the transaction amount to the card company’s central computer. The computer verifies that your charges are within acceptable limits and approves or denies the transaction. At the same time, the computer also conducts security checks. For example, if stores in Chicago and London registered sales using your card within an hour of each other, the system might sense that something is wrong and require you to call a customer service representative before the credit card company approves the second charge. Without reliable accounting systems, credit cards simply could not exist.

Accounting as an Aid to Decision Making Accounting information is useful to anyone making decisions that have economic consequences. Such decision makers include managers, owners, investors, and politicians. Consider the following examples: • When the engineering department of Apple Computer developed the iPad, accountants developed reports on the potential profitability of the product, including estimated sales and estimated production and selling costs. Managers used the reports to help decide whether to produce and market the product. • When QBC Information Services, a small consulting firm with five employees, decides who to promote (and possibly who to fire), the managing partner produces reports on the productivity of each employee and compares productivity to the salary and other costs associated with the employee’s work for the year. • When portfolio managers at Vanguard Group consider buying stock in either Ford Motor Company or Volkswagen Group, they consult published accounting reports to compare the most recent financial results of the companies. They must be able to compare Ford’s information reported in the accounting language of U.S. companies with that of Volkswagen reported in the accounting language of Europe. Understanding the information in the reports helps the managers decide which company would be the better investment choice. • When Chase Bank considers a loan to a company that wants to expand, it examines the historical performance of the company and analyzes projections the company provides about how it will use the borrowed funds to produce new business. Accounting helps decision making by showing where and when a company spends money and makes commitments. It also helps predict the future effects of decisions, and it helps direct attention to current problems, imperfections, and inefficiencies, as well as opportunities.

THE NATURE OF ACCOUNTING

7

Consider some basic relationships in the decision-making process:

Economic Event

Analyzed and Recorded

Accountant’s Analysis and Recording

Summarized into

Financial Statements

Communicated to

Information Users

Accountants analyze and record economic events. Periodically, accountants summarize the results of the events into financial statements. Users then rely on the financial statements to make decisions. Our focus includes all four boxes. All financial accounting courses cover the analysis and recording of information and the preparation of financial statements. We pay more attention to the underlying business processes creating the events and to the way in which the financial reports help decision makers to take action.

Financial and Management Accounting The financial statements we discuss in this book are common to all areas of accounting. Accountants often distinguish “financial accounting” from “management accounting” based on who uses the information. Financial accounting serves external decision makers, such as stockholders, suppliers, banks, and government agencies, and is the major focus of this book. In contrast, management accounting serves internal decision makers, such as top executives, department heads, college deans, hospital administrators, and people at other management levels within the organization.1 The two fields of accounting share many of the same procedures for analyzing and recording the effects of individual transactions. A common source of financial information used by investors and others outside the company is the annual report. The annual report is a document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects. Firms distribute their annual reports to stockholders automatically. Potential investors may request the report by calling the investor relations department of the company or by visiting the company’s Web site to access the report. In addition to the financial statements, annual reports usually include the following: 1. 2. 3. 4. 5. 6.

A letter from corporate management A discussion and analysis by management of recent economic events Footnotes that explain many elements of the financial statements in more detail The report of the independent registered public accounting firm (auditors) Statements by both management and auditors on the company’s internal controls Other corporate information

Some large companies also use their annual reports to promote the company, using pleasing photographs extensively to communicate their message. You can find annual reports for most companies on their Web sites, as described in the Business First box on page 8. Although all elements of the annual report are important, we concentrate on the principal financial statements and how accountants collect and report this information. You can also find U.S. companies’ financial statements in their Form 10-K filed annually with the Securities and Exchange Commission (SEC), the government agency responsible for regulating capital markets in the United States. U.S. Companies with publicly traded stock, that is, companies that sell shares in their ownership to the public, must file 10-Ks and many other forms with the SEC. The 10-K contains more than the basic financial statements, including detailed financial information beyond that included in most annual reports. A growing number of U.S. companies

1

For a book-length presentation of management accounting, see C. Horngren, G. Sundem, D. Burgstahler, and J. Schatzberg, Introduction to Management Accounting, 16th ed. (Upper Saddle River, NJ: Prentice-Hall, 2013), the companion volume to this textbook.

financial accounting The field of accounting that serves external decision makers, such as stockholders, suppliers, banks, and government agencies.

management accounting The field of accounting that serves internal decision makers, such as top executives, department heads, college deans, hospital administrators, and people at other management levels within an organization.

annual report A document prepared by management and distributed to current and potential investors to inform them about the company’s past performance and future prospects.

Form 10-K A document that U.S. companies file annually with the Securities and Exchange Commission. It contains the companies’ financial statements.

Securities and Exchange Commission (SEC) The government agency responsible for regulating capital markets in the United States.

publicly traded stock Shares in the ownership of a company that are sold to the public.

8

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

BUSINESS FIRST ANNUAL REPORTS AND THE INTERNET Until the last decade, annual reports were generally glossy documents produced by companies more than 3 months after year-end. In addition to being a primary source of financial information about the company, annual reports also contained much other information (some might call it propaganda) about the company. However, the Internet has changed and continues to change the way investors get information about a company. Today, more information is available more quickly on the Web than on paper. Most companies with publicly traded stock, and certainly the large ones, include their annual reports on their Web site. You can usually find a company’s annual report in a segment of its site called Investors or Investor Relations. Often this comes under a Category

heading Corporate Information, About the Company, or some such title included on the company’s home page. Most companies provide at least an indexed electronic version of their financial statements in PDF format. But many companies are providing files that are more flexible, mainly statements that users can download into Excel spreadsheets. This allows users to perform their own analyses of the data. There is even a competition for the best annual reports. The League of American Communications Professionals (LACP) rates annual reports based on how well they communicate their messages. The top 2010 annual reports by category, selected from more than 5,000 entries representing more than 24 countries, are as follows: Company

Country

Best Agency Report

National Savings Bank

Sri Lanka

Overall

Vossloh AG

Germany

Most Creative

RTL Group

Germany

Most Engaging

PT Adaro Energy Tbk

Indonesia

Most Improved

KOÇ Holding

Turkey

Best In-House Report

Daiwa House Industry Co., Ltd.

Japan

Best Shareholder Letter

Garanti Emeklilik

Turkey

Best Report Cover

Vossloh AG

Germany

Best Report Financials

Deufol AG

Germany

Best Report Narrative

U.S. Department of State

USA

Some executives use their company’s annual report to educate investors. Warren Buffett, chairman and CEO of Berkshire Hathaway, always includes a long letter explaining his philosophies as well as his company’s performance. In 2011, his letter contained 20  pages of insightful comments. For example, a few years ago he commented on the housing and credit crisis as one where “borrowers who shouldn’t have borrowed [were] being financed by lenders who shouldn’t have lent.” One year he even compared financial reporting to his golf game. Annual reports are venerable documents that have been useful to investors for many years. They are not

likely to go away. However, their content and format are changing. Use of the Internet opens up possibilities for presenting financial information (as well as other information) to investors that were previously impossible. This should lead to better information for those making investment decisions and therefore better functioning capital markets. Sources: LACP 2010 Annual Report Competition Results, http://www.lacp.com/2010vision/ competition.htm; Berkshire Hathaway, 2008 and 2011 Annual Reports.

are eliminating their expensive and glossy annual reports and simply issuing the 10-K to investors and potential investors. While decision makers are most interested in a company’s future performance, the information in an annual report or 10-K is largely historical. However, past performance is an important

THE BALANCE SHEET

9

input in predicting future success. Therefore, the annual report or 10-K enables decision makers to answer the following relevant questions: What is the financial picture of the organization at a moment in time? How well did the organization do during a period of time? Accountants answer these questions with four major financial statements: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders’ equity. The balance sheet focuses on the financial picture as of a given day. The income statement, cash flow statement, and statement of stockholders’ equity focus on the performance over a period of time. Usually the period is a year or one quarter of the year and the balance sheet shows the company’s status on the last day of the period. We discuss the balance sheet in this chapter, the income statement and statement of stockholders’ equity in Chapter 2, and the statement of cash flows in Chapter 5. After introducing the balance sheet, this chapter also explores several topics that are important to understanding the environment in which a business operates.

The Balance Sheet The balance sheet, also called the statement of financial position, shows the financial status of an organization at a particular instant in time. It is essentially a snapshot of the organization at a given date. It has two counterbalancing sections. One section lists the resources of the firm (everything the firm owns and controls—from cash to buildings, etc.). The other section lists the claims against the resources. The resources and claims form the balance sheet equation:

Some accountants prefer the following (equivalent) form of the balance sheet equation:

A financial statement that shows the financial status of an organization at a particular instant in time.

Assets - Liabilities = Owners’ equity We define the terms in this equation as follows:

balance sheet equation

Assets are economic resources that the company expects to help generate future cash inflows or reduce or prevent future cash outflows. Examples are cash, inventories, and equipment. Liabilities are economic obligations of the organization to outsiders, or claims against its assets by outsiders. An example is a debt to a bank. When a company takes out a bank loan, it generally signs a promissory note that states the terms of repayment. Accountants use the term notes payable to describe the existence of promissory notes. Owners’ equity (or owner’s equity if there is only one owner) is the owners’ claims on the organization’s assets. Because debt holders have first claim on the assets, the owners’ claim is equal to total assets less total liabilities. To illustrate the balance sheet, suppose Hector Lopez, a salaried employee of a local bicycle company, quits his job and opens his own bicycle shop, Biwheels Company, on January 2, 20X2. Lopez invests $400,000 in the business. Then, acting for the business, he borrows $100,000 from a local bank. That gives Biwheels $500,000 in assets, all currently in the form of cash. The opening balance sheet of this new business enterprise follows: Biwheels Company Balance Sheet January 2, 20X2

Cash

$500,000

Liabilities and Owner’s Equity Liabilities (Note payable) Lopez, capital

Total assets

$500,000

Describe the components of the balance sheet.

balance sheet (statement of financial position)

Assets = Liabilities + Owners’ equity

Assets

 OBJECTIVE 2

Total liabilities and owner’s equity

$100,000 400,000 $500,000

Because the balance sheet shows the financial status at a particular point in time, it always includes a specific date. The elements in this balance sheet show the financial status of the Biwheels Company as of January 2, 20X2. The Biwheels balance sheet lists the company’s assets ($500,000) on the left. They are balanced on the right by an equal amount of liabilities

Assets = Liabilities + Owners’ equity

assets Economic resources that a company expects to help generate future cash inflows or help reduce future cash outflows.

liabilities Economic obligations of the organization to outsiders, or claims against its assets by outsiders.

notes payable Promissory notes that are evidence of a debt and state the terms of payment.

owners’ equity The owners’ claims on an organization’s assets, or total assets less total liabilities.

10

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

and owner’s equity ($100,000 liability owed to the bank plus $400,000 paid in by Lopez). The double underscores (double ruling) under the column totals denote final numbers. Note that we always keep the left and right sides in balance. When someone first starts a business, the owners’ equity is equal to the total amount invested by the owner or owners. As illustrated by “Lopez, capital” in the Biwheels Company example, accountants often use the term capital instead of owners’ equity to designate an owner’s investment in the business. We can emphasize the residual, or “leftover,” nature of owners’ equity by expressing the balance sheet equation as follows: Owners’ equity = Assets - Liabilities net assets

This shows that the owners’ claims are the amount left over after deducting the liabilities from the assets. Accountants also use the term net assets to refer to assets less liabilities.

Assets less liabilities.

Balance Sheet Transactions  OBJECT IVE 3 Analyze business transactions and relate them to changes in the balance sheet.

entity An organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit.

transaction Any event that affects the financial position of an entity and that an accountant can reliably record in monetary terms.

Accountants record every transaction entered into by an entity. An entity is an organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit. For most of our examples the entity is a company. A transaction is any event that affects the financial position of an entity and that an accountant can reliably record in monetary terms. Every transaction affects the balance sheet. When accountants record a transaction, they make at least two entries so the total assets always equal the total liabilities plus owners’ equity. That is, they must maintain the equality of the balance sheet equation for every transaction. If a balance sheet balances before a transaction, adding or subtracting a single amount would necessarily leave the balance sheet out of balance. Because single entries cannot maintain the balance in the balance sheet, we often call the system that records transactions a double-entry accounting system, as we explain further in Chapter 3. Let’s take a look at some transactions of Biwheels Company to see how typical transactions affect the balance sheet. TRANSACTION 1, INITIAL INVESTMENT The first Biwheels transaction was the investment by the owner on January 2, 20X2. Lopez deposited $400,000 in a business bank account entitled Biwheels Company. The transaction affects the balance sheet equation as follows:

Assets

=

Liabilities

+

Owner’s Equity

Cash (1)

Lopez, Capital

+400,000

=

+400,000 (Owner investment)

This transaction increases both the assets, specifically Cash, and the owner’s equity, specifically Lopez, Capital. It does not affect liabilities. Why? Because Lopez’s business has no obligation to an outside party because of this transaction. We use a parenthetical note, “Owner investment,” to identify the reason for the transaction’s effect on owner’s equity. The total amounts on the left side of the equation are equal to the total amounts on the right side, as they should be. TRANSACTION 2, LOAN FROM BANK On January 2, 20X2, Biwheels Company also borrows

from Chase Bank, signing a promissory note for $100,000. The $100,000 increases Biwheels’ cash. The effect of this loan transaction on the balance sheet equation is as follows:

(1) (2) Bal.

Assets

=

Cash

=

+400,000

=

+100,000 500,000

= =

500,000

Liabilities Note Payable

+

Owner’s Equity

+

Lopez, Capital +400,000

+100,000 100,000 500,000

400,000

BALANCE SHEET TRANSACTIONS

11

The loan increases the asset, Cash, and increases the liability, Note Payable, by the same amount, $100,000. After completing the transaction, Biwheels has assets of $500,000, liabilities of $100,000, and owner’s equity of $400,000. As always, the sums of the individual account balances (abbreviated Bal.) on each side of the equation are equal. TRANSACTION 3, ACQUIRE STORE EQUIPMENT FOR CASH On January 3, 20X2, Biwheels acquires miscellaneous store equipment––shelves, display cases, lighting, et cetera––for $15,000 cash. Store equipment is an example of a long-lived asset—an asset that a company expects to use for more than 1 year.

Cash Bal. (3) Bal.

Assets +

Store Equipment

= =

Liabilities Note Payable

=

100,000

400,000

+15,000 15,000

= =

100,000

400,000

500,000 −15,000 485,000 500,000

+ +

long-lived asset An asset that a company expects to use for more than 1 year.

Owner’s Equity Lopez, Capital

500,000

This transaction increases one asset, Store Equipment, and decreases another asset, Cash, by the same amount. The form of the assets changes, but the total amount of assets remains the same. Moreover, the right-side items do not change. Biwheels can prepare a balance sheet at any point in time. The balance sheet for January 3, after the first three transactions, would look like this: Biwheels Company Balance Sheet January 3, 20X2 Assets Cash Store equipment Total assets

Liabilities and Owner’s Equity $485,000

Liabilities (Note payable)

$100,000

15,000 $500,000

Lopez, capital Total liabilities and owner’s equity

400,000 $500,000

Transaction Analysis Accountants record transactions in an organization’s accounts. An account is a summary record of the changes in a particular asset, liability, or owners’ equity, and the account balance is the total of all entries to the account to date. For example, Biwheels’ Cash account through January  3 shows increases of $400,000 and $100,000 and a decrease of $15,000, leaving an account balance of $485,000. The analysis of transactions is the heart of accounting. For each transaction, the accountant determines (1) which specific accounts the transaction affects, (2) whether it increases or decreases each account balance, and (3) the amount of the change in each account balance. After recording all the transactions for some period, the accountant will summarize these transactions into financial statements that managers, investors, and others use when making decisions. Exhibit 1-2 shows how to analyze a series of transactions using the balance sheet equation. We number the transactions for easy reference. Examine the first three transactions in Exhibit 1-2, which summarize the transactions we have already discussed. Next, consider how to analyze each of the following additional transactions: 4. January 4. Biwheels acquires bicycles from Trek for $120,000 cash. 5. January 5. Biwheels buys bicycle parts for $10,000 from Shimano. Biwheels will sell these parts in addition to the bicycles themselves. No cash changes hands on January 5. Rather, Shimano requires $4,000 by January 10 and the balance in 30 days. 6. January 6. Biwheels buys bicycles from Schwinn for $30,000. Schwinn requires a cash down payment of $10,000, and Biwheels must pay the remaining balance in 60 days.

account A summary record of the changes in a particular asset, liability, or owners’ equity.

12

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-2 Biwheels Company Analysis of Transactions for January 2 to January 12, 20X2 Description of Transactions

(1) Initial investment (2) Loan from bank (3) Acquire store equipment for cash (4) Acquire inventory for cash (5) Acquire inventory on credit (6) Acquire inventory for cash plus credit (7) Sale of equipment (8) Return of inventory acquired on January 6 (9) Payment to creditor Balance, January 12, 20X2

Assets = Liabilities + Owner’s Equity Merchandise Store Note Accounts Lopez, Cash + Inventory + Equipment = Payable + Payable + Capital +400,000 = +400,000 +100,000 = +100,000 –15,000 –120,000

–10,000 +1,000

+120,000

+15,000

= =

+10,000

=

+10,000

+30,000

+20,000

–1,000

= =

14,000

= = =

–800 –4,000 352,000 +

159,200 525,200

+

100,000

+

–800 –4,000 25,200+

400,000

525,200

7. January 7. Biwheels sells a store display case to a business neighbor after Lopez decides he dislikes it. Its selling price, $1,000, happens to be exactly equal to its cost. The neighbor pays cash. 8. January 8. Biwheels returns four bicycles (which it had acquired for $200 each) to Schwinn for full credit (an $800 reduction of the amount that Biwheels owes Schwinn). 9. January 10. Biwheels pays $4,000 to Shimano. 10. January 12. Lopez remodels his home for $35,000, paying by check from his personal bank account. Use the format in Exhibit 1-2 to analyze each transaction. Try to do your own analysis of each transaction before looking at the entries in the exhibit.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Transaction 10 does not appear in Exhibit 1-2. Why not?

Answer

accounts. It is important for readers of financial statements to identify the entity accounted for in the financial statements—which in our case is Biwheels, a business.

Transaction 10 is a personal transaction by Lopez and does not involve Biwheels as a business. Lopez would record it in his personal accounts, but it does not belong in Biwheels’ business

inventory

TRANSACTION 4, PURCHASE INVENTORY FOR CASH Inventory refers to goods held by the com-

Goods held by a company for the purpose of sale to customers.

pany for the purpose of sale to customers. The bicycles are inventory, or Merchandise Inventory, to Biwheels. Inventory increases by the amount paid for the bicycles, and cash decreases by the same amount.

BALANCE SHEET TRANSACTIONS

Cash Bal. (4) Bal.

Assets Merchandise Store + Inventory + Equipment

485,000 −120,000 365,000

+120,000 120,000

=

Liabilities + Owner’s Equity

=

Note Payable + Lopez, Capital

15,000

=

100,000

400,000

15,000

= =

100,000

400,000

500,000

500,000

TRANSACTION 5, PURCHASE INVENTORY ON CREDIT Companies throughout the world make most purchases on credit instead of for cash. An authorized signature of the buyer is usually good enough to ensure payment. We call this practice buying on open account. The buyer records the money owed on its balance sheet as an account payable. Thus, an account payable is a liability that results from a purchase of goods or services on open account. As Exhibit 1-2 shows for this transaction, the merchandise inventory (an asset account) of Biwheels increases, and we add an account payable to Shimano (a liability account) in the amount of $10,000 to keep the equation in balance. Both total assets and total liabilities and owner’s equity increase to $510,000.

Cash Bal.

Assets Merchandise Store + Inventory + Equipment

= =

Liabilities + Owner’s Equity Note Accounts Lopez, Payable + Payable + Capital

365,000

120,000

15,000

=

100,000

365,000

+10,000 130,000

15,000

= =

100,000

(5) Bal.

13

510,000

open account Buying or selling on credit, usually by just an “authorized signature” of the buyer.

account payable A liability that results from a purchase of goods or services on open account.

400,000 +10,000 10,000

400,000

510,000

TRANSACTION 6, PURCHASE INVENTORY FOR CASH PLUS CREDIT This transaction illustrates a

compound entry because it affects more than two balance sheet accounts (two asset accounts and one liability account, in this case). Merchandise inventory increases by the full amount of its cost regardless of whether Biwheels makes its payment in full now, in full later, or partially now and partially later. Therefore, Biwheels’ Merchandise Inventory (an asset account) increases by $30,000, Cash (an asset account) decreases by $10,000, and Accounts Payable (a liability account) increases by the difference, $20,000.

Cash Bal. (6) Bal.

Assets Merchandise Store + Inventory + Equipment

= =

Liabilities + Owner’s Equity Note Accounts Lopez, Payable + Payable + Capital

365,000

130,000

15,000

=

100,000

10,000

400,000

−10,000 355,000

+30,000 160,000

15,000

= =

100,000

+20,000 30,000

400,000

530,000

530,000

TRANSACTION 7, SALE OF ASSET FOR CASH This transaction increases Cash by $1,000 and decreases Store Equipment by $1,000. In this case, the transaction affects asset accounts only. One increases and one decreases, with no change in total assets. Liabilities and owner’s equity do not change.

compound entry A transaction that affects more than two accounts.

14

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

Cash Bal. (7) Bal.

355,000 +1,000 356,000

Assets Merchandise Store + Inventory + Equipment

= =

Liabilities + Owner’s Equity Note Accounts Lopez, Payable + Payable + Capital

160,000

15,000

=

100,000

30,000

400,000

160,000

–1,000 14,000

= =

100,000

30,000

400,000

530,000

530,000

TRANSACTION 8, RETURN OF INVENTORY TO SUPPLIER When a company returns merchandise

to its suppliers for credit, the transaction reduces its merchandise inventory account and reduces its liabilities. In this instance, the amount of the decrease on each side of the equation is $800.

Cash

Assets Merchandise Store + Inventory + Equipment

= =

Liabilities + Owner’s Equity Note Accounts Lopez, Payable + Payable + Capital

Bal. (8)

356,000

160,000

14,000

=

100,000

30,000

400,000

Bal.

356,000

–800 159,200

14,000

= =

100,000

–800 29,200

400,000

529,200

529,200

creditor

TRANSACTION 9, PAYMENT TO CREDITOR A creditor is a person or entity to whom the company

A person or entity to whom a company owes money.

owes money. For Biwheels, Shimano, who supplied the bicycle parts on credit, is a creditor. The payment to Shimano decreases both assets (Cash) and liabilities (Accounts Payable) by $4,000.

Cash Bal. (9) Bal.

356,000 –4,000 352,000

Assets Merchandise Store + Inventory + Equipment 159,200 159,200

= =

Liabilities + Owner’s Equity Note Accounts Lopez, Payable + Payable + Capital

14,000

=

100,000

29,200

400,000

14,000

= =

100,000

–4,000 25,200

400,000

525,200

 OBJECT IVE 4 Prepare a balance sheet from transactions data.

525,200

Preparing the Balance Sheet To prepare a balance sheet, we can compute a cumulative total for each account in Exhibit 1-2 at any date. The following balance sheet uses the totals at the bottom of Exhibit 1-2. Observe once again that a balance sheet represents the financial impact of all transactions up to a specific point in time, here January 12, 20X2. Biwheels Company Balance Sheet January 12, 20X2 Assets Cash Merchandise inventory Store equipment Total

Liabilities and Owner’s Equity $352,000 159,200 14,000 $525,200

Note payable Accounts payable Total liabilities Lopez, capital Total

$100,000 25,200 $125,200 400,000 $525,200

Although Biwheels could prepare a new balance sheet after each transaction, companies usually produce balance sheets only when needed by managers and at the end of each quarter for reporting to the public.

BALANCE SHEET TRANSACTIONS

Summary Problem for Your Review PROBLEM Analyze the following additional transactions of Biwheels Company. Begin with the balances shown for January 12, 20X2, in Exhibit 1-2 on page 12. Prepare a balance sheet for Biwheels Company on January 16, after recording these additional transactions. i. Biwheels pays $10,000 on the bank loan (ignore interest). ii. Lopez buys furniture for his home for $5,000, using his family’s charge account at Macy’s. iii. Biwheels buys more bicycles for inventory from Cannondale for $50,000. Biwheels pays one-half the amount in cash and owes one-half on open account. iv. Biwheels pays another $4,000 to Shimano.

SOLUTION See Exhibits 1-3 and 1-4. Note that we ignored transaction ii because it is wholly personal. However, visualize how this transaction would affect Lopez’s personal balance sheet. His assets, Home Furniture, would increase by $5,000, and his liabilities, Accounts Payable, would also increase by $5,000. EXHIBIT 1-3 Biwheels Company Analysis of Additional January Transactions (in $) Assets Description of Transaction Balance, January 12, 20X2 (i) Payment on bank loan (ii) Personal; no effect (iii) Acquire inventory, half for cash, half on credit (iv) Payment to supplier Balance, January 16, 20X2

Cash

+

352,000 –10,000

+

–25,000 –4,000 313,000

Merchandise Inventory + 159,200

+

Store Equipment 14,000

+50,000 +

209,200

+

14,000

536,200

Assets Cash Merchandise inventory Store equipment Total

=

Liabilities + Owner’s Equity

=

Note Payable

= =

100,000 –10,000

= = =

90,000

Liabilities: Note payable Accounts payable Total liabilities Lopez, capital Total

+

Lopez, Capital

+

25,200

+

400,000

+

+25,000 –4,000 46,200

+

400,000

=

Liabilities and Owner’s Equity $313,000 209,200 14,000 $536,200

Accounts Payable

+

$ 90,000 46,200 $136,200 400,000 $536,200

536,200

EXHIBIT 1-4 Biwheels Company Balance Sheet January 16, 20X2

Examples of Actual Corporate Balance Sheets To become more familiar with the balance sheet, consider the balance sheets for Starbucks and Jack in the Box for 2011, shown in Exhibit 1-5. (We have omitted many details present in the actual balance sheets to simplify and condense the examples.) Both Starbucks and Jack in the Box provide food services, but their strategies are different. Starbucks focuses on coffee, has

15

16

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-5 Comparative Consolidated Condensed Balance Sheets, October 2, 2011 ($ in millions)

Starbucks

Jack in the Box

Assets Cash and cash equivalents Inventories Prepaid expenses Property, plant, and equipment Other assets Total assets Liabilities and Owners’ Equity Accounts payable Long-term debt Other liabilities Total liabilities Total owners’ equity Total liabilities and owners’ equity

$1,148.1 965.8 161.5 2,355.0

$

11.4 38.9 18.7 855.4

2,730.0 $7,360.4

507.9 $1,432.3

$ 540.0 549.5 1,883.6 2,973.1 4,387.3 $7,360.4

$

94.3 447.3 484.7 1,026.3 406.0 $1,432.3

17,000 outlets, more than six times as many as Jack in the Box’s 2,500, and has expanded internationally to 50 countries. Jack in the Box sells fast food and has outlets primarily in the western and southern United States. From the companies’ balance sheets, we learn that Starbucks has more than five times as many total assets as Jack in the Box, but it has less than three times more property, plant, and equipment. Starbucks has invested ($2,355,000,000 ÷ 17,000) = $138,529 in property, plant, and equipment for each coffee shop, while Jack in the Box has invested ($855,400,000 ÷ 2,500) = $342,160 per location, two-and-a half times as much. Just think about the investment required by a drive-in restaurant compared with that in a coffee shop—the difference is logical. We also see that Starbucks has much more cash, almost 23% more long-term debt, and more than ten times the owners’ equity. Notice that on the balance sheets of both companies the total assets are equal to the total liabilities and owners’ equity. Every balance sheet maintains this equality. Details about various items in the balance sheet will gradually become more understandable as each chapter explains the nature of the various major financial statements and examines their components.

Summary Problem for Your Review PROBLEM Exhibit 1-6 contains Starbucks’ condensed balance sheets for 2010 and 2011. Respond to the following questions: 1. As of what date were the 2010 and 2011 balance sheets prepared? Are these points in time or spans of time? 2. What are total assets for each of the 2 years shown in the balance sheets? What balance sheet accounts changed the most over the 2 years? 3. Total assets increased by $974.5 million from October 3, 2010, to October 2, 2011. What was the change in total liabilities plus owners’ equity over that same time period? 4. Of the following items on Starbucks’ balance sheet, which are assets and which are liabilities: Property, Plant, and Equipment; Cash and Cash Equivalents; Long-Term Debt; Inventories; and Accounts Payable?

SOLUTION 1. Starbucks presents two balance sheets. The most recent is dated October 2, 2011, and the earlier one is dated October 3, 2010. These are both points in time; all balance sheets represent a single point in time.

TYPES OF OWNERSHIP

Assets Cash and cash equivalents Inventories Prepaid expenses Property, plant, and equipment

October 2, 2011

October 3, 2010

$1,148.1

$1,164.0

965.8

543.3

161.5

156.5

2,355.0

2,416.5

Other assets

2,730.0

2,105.6

Total assets

$7,360.4

$6,385.9

$ 540.0

$ 282.6

17

EXHIBIT 1-6 Starbucks Corporation Consolidated Balance Sheets ($ in millions)

Liabilities and Owners’ Equity Accounts payable Long-term debt

549.5

549.4

Other liabilities

1,883.6

1,871.6

Total liabilities

2,973.1

2,703.6

Total owners’ equity

4,387.3

3,682.3

$7,360.4

$6,385.9

Total liabilities and owners’ equity

2. Total assets increased by $974.5 million, from $6,385.9 million to $7,360.4 million. Most of the increase occurred in Inventory ($422.5 million) and Other Assets ($624.4 million). Property, plant, and equipment decreased by $61.5 million despite the increase in total assets. 3. Total Liabilities and Owners’ Equity increased by the same amount as the increase in total assets: $974.5 million. The two increases must be the same to keep the balance sheet equation in balance. 4. Property, Plant, and Equipment, Cash and Cash Equivalents, and Inventories are assets. Longterm Debt and Accounts Payable are liabilities.

Types of Ownership Although most accounting processes are the same for all types of companies, a few differences in accounting for owners’ equity arise because of the legal structure of the company. We next look at three basic forms of ownership structures for business entities: sole proprietorships, partnerships, and corporations.

OBJECTIVE 5 Compare the features of sole proprietorships, partnerships, and corporations.

Sole Proprietorships A sole proprietorship is a business with a single owner. Most often, the owner is also the manager. Therefore, sole proprietorships tend to be small businesses such as local stores and restaurants and professionals such as dentists or attorneys who operate alone. Biwheels started out as a sole proprietorship owned and operated by Hector Lopez. From an accounting viewpoint, a sole proprietorship is a separate entity that is distinct from the proprietor. Thus, the cash in a dentist’s business account is an asset of the dental practice, whereas the cash in the dentist’s personal account is not. Similarly, Lopez’s remodeling of his home (see transaction 10, p. 12) was a personal transaction, not a business transaction.

Partnerships A partnership is an organization that joins two or more individuals who act as co-owners. Many auto dealerships are partnerships, as are groups of physicians, attorneys, or accountants who group together to provide services. Partnerships can be gigantic. The largest international accounting firms have thousands of partners. Again, from an accounting viewpoint, each partnership is an individual entity that is separate from the personal activities of each partner.

Corporations Most large businesses, including all 30 Dow companies listed in Exhibit 1-1 (p. 4), are corporations. Corporations are business organizations created under state laws in the United States. The  owners of a corporation have limited liability, which means that corporate creditors (such

sole proprietorship A business with a single owner.

partnership A form of organization that joins two or more individuals together as co-owners.

corporation A business organization that is created by individual state laws.

limited liability A feature of the corporate form of organization whereby corporate creditors (such as banks or suppliers) ordinarily have claims against the corporate assets only, not against the personal assets of the owners.

18

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

privately owned (closely held, unlisted) A corporation owned by a family, a small group of shareholders, or a single individual, in which shares of ownership are not publicly sold.

as banks or suppliers) ordinarily have claims against the corporate assets only, not against the personal assets of the owners. In contrast, owners in sole proprietorships and partnerships are usually personally liable for any obligations of the business. (An exception is a partnership structured as a limited liability company [LLC], which limit the liability of partners.) Another difference is that the owners of proprietorships and partnerships are typically active managers of the business, whereas large corporations generally hire professional managers. Ownership shares in most large corporations consist of publicly traded stock. This means that the company sells shares in its ownership to the public. Purchasers of the shares become shareholders (or stockholders). Large publicly traded corporations often have thousands of  shareholders. In contrast, some corporations are privately owned by families, small groups of shareholders, or a single individual, with shares of ownership not sold to the public. These are also called closely held or unlisted corporations. Corporations in the United States often use one of the abbreviations Co., Corp., or Inc. in their names. Internationally, organizational forms similar to corporations are common. In the United Kingdom, such companies frequently use the word “limited” (Ltd.) in their names. In Germany you will see AG or GmbH, while in Spain corporations use the initials S.A. Corporate laws vary in details across countries, but the basic characteristics of corporations are quite universal.

Advantages and Disadvantages of the Corporate Form

stock certificate Formal evidence of ownership shares in a corporation.

The corporate form of organization has many advantages. We have already discussed limited liability. What are some other advantages? One is easy transfer of ownership. To sell shares in its ownership, the corporation usually issues stock certificates as formal evidence of ownership. Some shareholders may hold the physical certificates. However, the most common type of ownership is a brokerage account that electronically registers ownership shares. Owners of these shares, whether they hold them physically or electronically, can sell them to others. Numerous stock exchanges in the United States and worldwide facilitate buying and selling of shares. Investors buy and sell nearly 2 billion shares on an average day on the New York Stock Exchange (NYSE), the largest exchange in the world with about 2,300 listed companies valued at $12.4 trillion. Another U.S. exchange, NASDAQ, lists the stock of more than 2,700 companies with a total market value of $3.5 trillion. While the NASDAQ is composed primarily of smaller, tech-oriented companies, it also includes Microsoft, Intel, Yahoo!, Ebay, Comcast, and a few other large companies, mostly technology companies, among its listings. Other large exchanges include those in Tokyo, Hong Kong, Shanghai, Frankfurt, and London. Companies can be listed on more than one exchange. Many Japanese, German, and British firms have shares traded on the NYSE, and many U.S. companies list their shares abroad. The London Stock Exchange is one of the most international of the exchanges with listed companies from 70 countries. Exhibit 1-7 displays just a few of the international companies listed on the London exchange. Because owners can easily trade shares of stock, corporations have the advantage of raising ownership capital from hundreds or thousands of potential stockholders. For example, General Electric has millions of stockholders, owning a total of nearly 10 billion shares of stock. More than 60 million shares of General Electric trade hands on a typical day. A corporation also has the advantage of continuity of existence. The life of a corporation is indefinite––it continues even if its ownership changes. In contrast, proprietorships

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Biwheels is organized as a sole proprietorship. What would be the biggest advantage for Mr. Lopez in converting it to a corporation?

Answer As a sole proprietorship, Mr. Lopez is personally liable for all the liabilities of Biwheels. If it were a corporation, his liability would

be limited to the investment he has already made. There may also be tax advantages, and Mr. Lopez would find it easier to sell part of the business by issuing shares if it is a corporation.

ACCOUNTING DIFFERENCES BETWEEN PROPRIETORSHIPS, PARTNERSHIPS, AND CORPORATIONS

19

EXHIBIT 1-7 Sample of Companies Traded on the London Stock Exchange Company

Country

Company

Country

Platinum Australia Ltd. Grupo Clarín SA

Australia Argentina

Kazkommertsbank JSC

Kazakhstan

Press Corp.

Malawi

Arab Insurance Group

Bahrain

Steppe Cement

Malaysia

Beximco Pharmaceuticals

Bangladesh

Go PLC

Malta

Worldsec

Bermuda

Royal Dutch Shell

Netherlands

Canadian Pacific Railways

Canada

Norsk Hydro ASA

Norway

Integra Group

Cayman Islands

MCB Bank

Pakistan

China Petroleum and Chemical Corp.

China

Telekomunikacja Polska

Poland

Hrvatski Telekom

Croatia

Qatar Telecom

Qatar

Komercˇni Banka

Czech Republic

Bank of Ireland

Republic of Ireland

Suez Cement Company

Egypt

Gazprom OAO

Russia

Powerflute Oyj

Finland

Harmony Gold Mining Co.

South Africa

Groupe Eurotunnel SA

France

Hyundai Motor Co.

South Korea

Siemens AG

Germany

Telefónica SA

Spain

National Bank of Greece

Greece

XCounter

Sweden

Tisza Chemical Group

Hungary

IBC Financial Group

Switzerland

Amtek Auto

India

Sunplus Technology

Taiwan

Emblaze Systems

Israel

Boeing Co.

USA

Honda Motor Co.

Japan

Abbott Laboratories

USA

Sony Corp.

Japan

General Electric

USA

and partnerships in the United States officially terminate on the death or complete withdrawal of an owner. Finally, tax laws may favor a corporation or a partnership or a proprietorship. This depends heavily on the personal tax situations of the owners and is beyond the scope of this book. Although only 20% of U.S. businesses are corporations, they do 90% of the business. The 70% of businesses that are sole proprietorships generate only about 6% of the business activity. Because of the economic importance of corporations, this book emphasizes the corporate form of ownership.

Accounting Differences Between Proprietorships, Partnerships, and Corporations All business entities account for assets and liabilities similarly. However, corporations account for owners’ equity differently than do sole proprietorships and partnerships. The basic concepts that underlie the owners’ equity section of the balance sheet are the same for all three forms of ownership––owners’ equity always equals total assets less total liabilities. However, we often label the owners’ equities for proprietorships and partnerships with the word capital. In contrast, we call owners’ equity for a corporation stockholders’ equity or shareholders’ equity . Examine the possibilities for the Biwheels Company in Exhibit 1-8 . The accounts for the proprietorship and the partnership show owners’ equity as straightforward records of the capital invested by the owners. (In the partnership example, we assume that Lopez has two partners, each with a 10% stake in Biwheels.) For a corporation, though, we call the total capital investment by owners, both at and subsequent to the inception of the business, paid-in capital. We record it in two parts: common stock (or capital stock) at par value and paid-in capital in excess of par value. Let’s next explore what par value means.

 OBJECTIVE 6

Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or a partnership.

stockholders’ equity (shareholders’ equity) Owners’ equity of a corporation. The excess of assets over liabilities of a corporation.

paid-in capital The total capital investment in a corporation by its owners, both at and subsequent to the inception of the business.

20

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-8 Owners’ Equity for Different Types of Organizations

OWNER’S EQUITY FOR A PROPRIETORSHIP (Assume Hector Lopez Is the Sole Owner) $400,000

Hector Lopez, capital OWNERS’ EQUITY FOR A PARTNERSHIP (Assume Lopez Has Two Partners) Hector Lopez, capital

$320,000

Alex Handl, capital

40,000

Susan Eastman, capital

40,000 $400,000

Total partners’ capital OWNERS’ EQUITY FOR A CORPORATION (Assume Lopez Has Incorporated) Stockholder’s equity: Paid-in capital: Capital stock, 10,000 shares issued at par value of $10 per share

$100,000 300,000

Paid-in capital in excess of par value

$400,000

Total paid-in capital

The Meaning of Par Value par value (stated value) The nominal dollar amount printed on stock certificates.

paid-in capital in excess of par value (additional paid-in capital) When issuing stock, the excess of the total amount the company receives for the stock over the par value of the shares.

Many states require stock certificates to have some dollar amount printed on them. We call this amount par value or stated value. Typically, a company sells stock at a price that is higher than its par value. The excess of the total amount the company receives for the stock and the par value of the shares is called paid-in capital in excess of par value or additional paid-in capital. This distinction is of little economic importance, and we introduce it here only because you will frequently encounter it in actual financial statements. Let’s take a closer look at par value by altering our Biwheels example. We now assume that Biwheels is a corporation and that Lopez received 10,000 shares of stock for his $400,000 investment. Thus, he paid $40 per share. The par value is $10 per share, and the paid-in capital in excess of par value is $30 per share. The total ownership claim of $400,000 arising from the investment is split between two equity claims, one for $100,000 capital stock at par value and one for $300,000 paid-in capital in excess of par value: Total Paid-in Capital

=

Capital Stock at Par

+

Paid-in Capital in Excess of Par Value

(Average Issue Price per Share (Par Value per Share [(Average Issue Price per Share * Number of Shares Issued) = * Number of Shares Issued) + - Par Value per Share) * Number of Shares Issued]

common stock Par value of the stock purchased by common shareholders of a corporation.

($40 × 10,000)

=

($10 × 10,000)

+

[($40 - $10) * 10,000]

$400,000

=

$100,000

+

$300,000

Exhibit 1-9 shows the paid-in capital for Starbucks as of October 2, 2011. Notice that Starbucks separates the par value from the capital in excess of par value. It uses the label common stock to describe the par value of the stock purchased by the common shareholders. Starbucks uses “other additional paid-in capital” to describe the amount paid-in above the par value. Some companies, such as General Motors, use a less descriptive term, capital surplus, for this amount. Although it would be nice to use only one phrase for each item in this textbook, the world is full of different words used for identical accounting items. One of our goals is to help you to prepare to read and understand actual financial statements and reports. Therefore, we use many of the synonyms you will encounter when reading financial statements.

ACCOUNTING DIFFERENCES BETWEEN PROPRIETORSHIPS, PARTNERSHIPS, AND CORPORATIONS

Starbucks October 2, 2011 Common stock ($.001 par value)—authorized, 1,200.0 shares; issued and outstanding, 744.8 shares Other additional paid-in capital Total paid-in capital

EXHIBIT 1-9 Paid-in Capital for Starbucks $ 0.7 40.5 $41.2

The par value per share for Starbucks is only $0.001, much smaller than the amount investors paid Starbucks for the common shares. We know this because the capital in excess of par value is much larger than the common stock at par value. The extremely small amount of par value is common in practice and illustrates the insignificance of par value in today’s business world. Some companies provide a single total for par value and additional paid-in capital on their balance sheets. This combined reporting is acceptable because readers of financial statements would learn little of significance from separating the two components. Just remember that the sum of common stock at par value and additional paid-in capital is the amount that owners actively contributed to the firm. These common stockholders have a “residual” ownership in the corporation, that is, they have a claim on whatever is left over after all other claimants have been paid at liquidation. This could be a large amount for a successful company or nothing for an unsuccessful one. Although these paid-in capital accounts identify the amount the stockholders contributed, this is not the amount they might receive now or in the future. Common stockholders buy shares of stock as investments. Sometimes they purchase the stock from the company. In such a case, the company increases both its cash and its paid-in capital. However, the majority of stock transactions occur between stockholders. Often, a broker matches a buyer and seller using the services of one of the stock exchanges such as the NYSE or the NASDAQ. When Mary sells 100 shares of Starbucks stock to Carlos, the transaction does not affect Starbucks’ balance sheet. Starbucks does not receive cash, and it issues no new shares. The only effect on Starbucks will be to replace Mary with Carlos on the corporate records as an owner of the 100 shares of stock.

Summary Problems for Your Review PROBLEM “If I purchase 100 shares of the outstanding stock of Google, I invest my money directly in that corporation. Google must record that event.” Do you agree? Explain.

SOLUTION Stockholders invest directly in a corporation only when the corporation originally issues the stock. For example, Google may issue 100,000 shares of stock at $30 per share, bringing in $3 million to the corporation. This is a transaction between the corporation and the stockholders. It affects the corporate financial position: Cash $3,000,000

21

Stockholders’ equity $3,000,000

Subsequently, an original stockholder (Kyung Kim) may sell 100 shares of that stock to another individual (Jane Soliman) for $50 per share. This is a private transaction. The corporation receives no cash. Of course, the corporation records the fact that Soliman now owns the 100  shares originally owned by Kim, but the corporate financial position is unchanged. Accounting focuses on the business entity. Private stock trades of the owners have no effect on the financial position of the entity.

PROBLEM “One individual can be an owner, an employee, and a creditor of a corporation.” Do you agree? Explain.

(in millions except per share amounts)

common stockholders The owners who have a “residual” ownership in the corporation.

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SOLUTION The corporation enters contracts, hires employees, buys buildings, and conducts other business. The president, the other officers, and all the workers are employees of the corporation. Thus, Bill Gates could own some of the capital stock of Microsoft and also be an employee. Because money owed to employees for salaries is a liability, he could be an owner, an employee, and a creditor. Similarly, Carmen Smith could be an employee of a cell phone company, a stockholder of the company, and also receive cell phone services from the same company. Suppose she has earned wages that the company has not yet paid and she has not yet paid her current cell phone bill. She is simultaneously an owner, employee, customer, creditor, and debtor of the company.

Stockholders and the Board of Directors board of directors A body elected by the shareholders to represent them. It is responsible for appointing and monitoring the managers, among other duties.

In sole proprietorships and partnerships, the owners are usually also managers. In contrast, corporate shareholders (that is, the owners) delegate responsibility for management of the company to professional managers. To oversee managers, the shareholders elect a board of directors. Among other duties, the board of directors is responsible for appointing and monitoring the managers, as shown in the following diagram:

Elect Stockholders

chief executive officer (CEO) The top manager in an organization.

Board of Directors

Appoint Managers

Why is the separation of ownership and management in a corporation desirable? It allows stockholders to invest resources without needing to devote time to managing. In addition, the company can select managers for their managerial skills, not their ability to invest large sums of money in the firm. The board of directors is the link between stockholders and managers. The board’s duty is to ensure that managers act in the best interests of shareholders. In some of the business scandals of the last decade, shareholders have accused boards of not fulfilling this responsibility and thereby causing shareholders to lose billions of dollars. When boards of directors do their duty in monitoring management, the corporate form of organization has proved to be effective. When such monitoring fails, management may line its own pockets at the expense of shareholders. When management has too much influence on the election of board members, perhaps by nominating a slate of candidates beholden to management, such monitoring may fail. Additionally, in the United States it has been common for the top manager (chief executive officer or CEO) to also serve as chairman of the board. It is difficult for the chairman of the board to monitor the CEO when they are the same person. In the United Kingdom and much of the rest of Europe it is common for the chairman of the board to be an independent director rather than a member of management, and this practice is becoming more common in the United States. In the past, other top managers of the company, such as the president, financial vice president, and marketing vice president, have also been members of the board of directors. However, it is increasingly common for these company officers to attend board meetings as needed but not to serve as voting members of the board. Independent members of a board often include CEOs and presidents of other corporations, university presidents and professors, attorneys, and community representatives. For example, the eleven-member board of Starbucks in 2012 included CEO and Board Chair Howard Schultz, three retired executives from companies other than Starbucks, three current executives of major

REGULATION OF FINANCIAL REPORTING

23

companies that do not compete with Starbucks, an investment banker, a mutual fund president, a venture capitalist, and a foundation president. Although boards once often had 15–20 members, many companies are moving toward having smaller boards of directors that include fewer members of the company’s management team.

Regulation of Financial Reporting Financial statements are the result of a measurement process that rests on a set of principles. If every accountant used a different set of measurement rules, investors would find it difficult to use and compare financial statements. For example, consider the recording of an asset such as a machine on the balance sheet. If one accountant listed the purchase cost, another the amount for which the company could sell the used machine, and others listed various other amounts, the readers of financial statements would be confused. It would be as if each accountant were speaking a different language. Therefore, accountants have agreed to apply a common set of measurement principles—that is, a common language—to report information on financial statements.

OBJECTIVE 7 Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS.

Generally Accepted Accounting Principles Generally accepted accounting principles (GAAP) is the term that applies to all the broad concepts and detailed practices to be followed in preparing and distributing financial statements. There are two primary sets of GAAP. Companies reporting in more than 100 countries around the world, including all European Union countries, use International Financial Reporting Standards (IFRS). U.S. companies use Financial Accounting Standards, usually referred to as U.S. GAAP. Each set of standards contains conventions, rules, and procedures that determine acceptable accounting practices. The standards are identical on most significant issues. However, there are a few conceptual differences and more differences in specific measurement details. Authorities are working to eliminate (or at least minimize) the differences in standards between IFRS and U.S. GAAP statements, but many differences are likely to remain in the near future. Until recently, all companies with stock traded on U.S. stock exchanges had to report using U.S. GAAP or to prepare a report detailing the differences between their statements and statements prepared under U.S. GAAP. However, foreign companies listed on U.S. exchanges can now use IFRS for their financial statements. While companies based in the United States must still use U.S. GAAP, many accountants believe that U.S. regulators will allow all companies to use IFRS within a few years. Why? Because they believe that global capital markets will function more efficiently if all companies issue financial statements based on the same GAAP. In this book we focus on reporting regulations under U.S. GAAP. Many of the differences between IFRS and U.S. GAAP are in relatively minor details that are beyond the scope of an introductory text. However, we do point out significant differences between U.S. GAAP and IFRS requirements. But before exploring the standards, let’s look more closely at the bodies that set the standards.

generally accepted accounting principles (GAAP) The term that applies to all the broad concepts and detailed practices to be followed in preparing and distributing financial statements. It includes all the conventions, rules, and procedures that together comprise acceptable accounting practice.

International Financial Reporting Standards (IFRS) The set of GAAP that applies to companies reporting in more than 100 countries around the world.

Financial Accounting Standards (U.S. GAAP) The set of GAAP that applies to financial reporting in the United States.

Standard Setting Bodies Until recently, most accounting standards were set country by country. However, forces ranging from the creation of the European Union to the emergence of global financial markets have resulted in most companies adopting one of the two main competing sets of standards—U.S. GAAP or IFRS. The Financial Accounting Standards Board (FASB) has been responsible for establishing U.S. GAAP since 1973. The FASB is an independent entity within the private sector consisting of seven individuals who work full-time with a staff to support them. A mandatory fee assessed on all public companies and sales of publications provide the FASB’s annual budget of about $32 million. Between 1973 and 2009 the FASB issued 168 Financial Accounting Standards, and in 2009 it compiled all standards and other elements of U.S. GAAP into a single searchable database, the FASB Accounting Standards Codification. The Codification classifies U.S. GAAP by topic to make it easy to research financial reporting issues. All changes in U.S. GAAP are now made via Accounting Standards Updates. These updates amend the Codification so that it will always be an up-to-date source of U.S. GAAP. As of early 2012 there were 55 such updates.

Financial Accounting Standards Board (FASB) The independent private sector body that is responsible for establishing GAAP in the United States.

FASB Accounting Standards Codification A compilation of all standards and other elements of U.S. GAAP into a single searchable database that is organized by topic to make it easy to research financial reporting issues.

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

The U.S. Congress has charged the Securities and Exchange Commission (SEC) with the ultimate responsibility for specifying GAAP for companies with publicly traded stock. However, the SEC has formally delegated much rule-making power to the FASB. This public sector– private sector authority relationship can be sketched as follows:

Congress

SEC

FASB

Issues pronouncements on various accounting topics. These pronouncements govern the preparation of typical financial statements.

International Accounting Standards Board (IASB) An international body established to develop, in the public interest, a single set of high-quality, understandable, and enforceable global accounting standards.

Note that Congress can overrule both the SEC and the FASB, and the SEC can overrule the FASB. The FASB and the SEC work closely together and seldom have public disagreements. However, on occasion Congress has overruled FASB decisions. The accounting for stock options is an example of this political interplay. In the 1990s, Congress heeded the pleas of constituents and donors and threatened to overrule the FASB if it required companies to recognize stock options granted to managers as an expense of doing business. This caused the FASB to rescind such a proposed requirement and issue a standard that allowed companies flexibility in accounting for stock options. In 2001 and 2002, the FASB received much criticism for submitting to the wishes of Congress. In 2004, after the financial turmoil of the early 2000s and with support from the SEC, the FASB was able to assert its original plan and require companies to record an expense for stock options. Although you may not understand the accounting for stock options at this point, you can see from the example that the setting of accounting principles in the United States (and, indeed, globally) is a complex political process involving heavy interactions among the affected parties: public regulators (Congress and the SEC), private regulators (FASB), companies, those in the public accounting profession, representatives of investors, and other interested groups and lobbyists. GAAP is not a set of arcane rules of interest only to accountants. GAAP can affect many people and companies, and it is an important part of a country’s public policy. The International Accounting Standards Board (IASB), which was established in 2001 (as successor to the International Accounting Standards Committee) “to develop, in the public interest, a single set of high quality, understandable and enforceable global accounting standards,” sets International Financial Reporting Standards (IFRS). The IASB has 16 members who represent a diversity of geographic and professional backgrounds. Nearly 120 counties require or permit the use of IFRS. A significant step for international accounting standards was the required use of IFRS by companies in the European Union for financial statements prepared after 2005. Of the G20 countries––19 countries plus the European Union, which represent around 90% of global gross national product––all but one either require or permit IFRS or are converging their standards to IFRS. The motivation for this conformity movement lies in the explosive growth of international commerce. Increasingly, investors commit their money worldwide either as individuals or through retirement accounts or mutual funds. Companies rely on international capital to finance

THE ACCOUNTING PROFESSION

25

their growth. Therefore, comparability of financial information across companies in different countries is important. Examples of major multinational firms that now publish their financial statements in conformity with IFRS are Allianz (Germany), Nestlé (Switzerland), Nokia (Finland), and Shanghai Petrochemical (China).

Credibility and the Role of Auditing The separation of owners and managers in a corporation creates potential problems in getting truthful information about the performance of a company. Corporate managers have the best access to information about the company, but they may also have incentives to make the company’s performance look better than it really is. Perhaps doing so will make it easier to raise money to open new stores, or perhaps it will lead to increases in managers’ compensation. In addition, managers often believe that company conditions are better than they really are because managers are optimistic about the good decisions they have made and the plans they are implementing. The problem shareholders face is that they must rely on managers to tell the truth, because shareholders cannot personally see what is going on in the firm. One way to solve this credibility problem is to introduce an honorable, expert third party. In the area of financial statements, this third party is an independent registered public accounting firm, commonly called the auditor. The auditor examines the information that managers use to prepare the financial statements and provides assurances about the credibility of those statements. Auditors do not provide a guarantee that everything on the financial statements is correct because they examine only a sample of the data underlying the financial statements. However, on seeing the auditor’s assurance that the financial statements fairly present a company’s economic circumstances, shareholders and potential shareholders can feel more comfortable about using the information to guide their investing activity.

OBJECTIVE 8 Describe auditing and how it enhances the value of financial information.

auditor A person or firm who examines the information used by managers to prepare the financial statements and attests to the credibility of those statements.

The Certified Public Accountant and the Auditor’s Opinion The desire for third-party assurance about the credibility of financial statements gave rise to the profession of public accountants––accountants who offer services to the general public on a fee basis. Providing credibility requires individuals who have both the technical knowledge to assess financial statements and the integrity and independence to assure that they will honestly tell shareholders and other interested parties if management has not produced reliable statements. Such professionals are called certified public accountants (CPAs) in many countries, including the United States, and chartered accountants (CAs) in many others, including most British Commonwealth countries. In the United States, each state has a Board of Accountancy that sets standards of both knowledge and integrity that public accountants must meet to be licensed as a certified public accountant (CPA). Only CPAs have the right to issue official opinions on financial statements in the United States. To assess management’s financial disclosures, CPAs conduct an audit—an examination of a company’s transactions and the resulting financial statements. The auditor’s opinion (also called an independent opinion) describes the scope and results of the audit. Companies include the opinion with the financial statements in their annual reports and 10-K filings. Auditors use a standard phrasing for their opinions, as illustrated by the opinion rendered by a large CPA firm, Deloitte & Touche LLP, for Starbucks Corporation that appears in Exhibit 1-10. Some phrases in this opinion may be unfamiliar now, but they will become more clear as you read further. For now, reflect on the fact that auditors do not prepare a company’s financial statements. Instead, the auditor’s opinion is the public accountant’s judgment about whether the financial statements prepared by management fairly present economic reality.

The Accounting Profession To understand auditors and auditors’ opinions, you need to know something about the accounting profession. There are many ways to classify accountants, but the easiest and most common way is to divide them into public and private accountants. We already learned that public accountants offer services to the general public for a fee. All other accountants are private accountants. This category consists not only of those individuals who work for businesses, but also of those who work for government agencies, including the Internal Revenue Service (IRS), and other nonprofit organizations.

public accountants Accountants who offer services to the general public on a fee basis.

certified public accountant (CPA) In the United States, a person earns this designation by meeting standards of both knowledge and integrity set by a State Board of Accountancy. Only CPAs can issue official opinions on financial statements in the United States.

audit An examination of a company’s transactions and the resulting financial statements.

auditor’s opinion (independent opinion) A report describing the scope and results of an audit. Companies include the opinion with the financial statements in their annual reports.

private accountants Accountants who work for businesses, government agencies, and other nonprofit organizations.

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-10 Report of Independent Auditors

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Starbucks Corporation Seattle, Washington We have audited the accompanying consolidated balance sheets of Starbucks Corporation and subsidiaries (the “Company”) as of October 2, 2011 and October 3, 2010, and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the three years in the period ended October 2, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Starbucks Corporation and subsidiaries as of October 2, 2011 and October 3, 2010, and the results of their operations and their cash flows for each of the three years in the period ended October 2, 2011, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of November 18, 2011, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated November 18, 2011, expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP Seattle, Washington November 18, 2011

Public Accounting Firms Public accountants work for firms that vary in size and in the type of accounting services they perform. There are small sole proprietorships and partnerships that focus entirely on income tax reporting and bookkeeping services. Other small- to medium-sized firms provide some audit services, as well, and generally serve local, regional, or national clients. There are also a handful of large firms with more than 100,000 partners and offices located throughout the world. Such enormous firms are necessary because their clients also tend to be enormous. For instance, one large CPA firm reported that its annual audit of one client takes the equivalent of 72 accountants working a full year. Another client has 300 separate corporate entities in 40 countries that it must ultimately consolidate into one set of overall financial statements. The four largest international public accounting firms are as follows: • • • •

Deloitte Touche Tohmatsu Ernst & Young KPMG PwC

These four firms audit more than 95% of the companies listed on the NYSE. They have annual billings in excess of $22 billion each.

Audit Regulation American Institute of Certified Public Accountants (AICPA) The principal professional association of CPAs.

Until the last decade, the U.S. audit profession regulated itself through the American Institute of Certified Public Accountants (AICPA), a professional association of CPAs. The AICPA has counterparts in other parts of the world, such as the Institute of Chartered Accountants in England and Wales (ICAEW) and the Association of Chartered Certified Accountants (ACCA).

THE ACCOUNTING PROFESSION

The International Auditing and Assurance Standards Board (IAASB), established by the International Federation of Accountants, is working to standardize audit regulation around the globe, but regulation of auditing continues to differ significantly across countries. We will focus on the situation in the United States. Most government regulation of the accounting profession in the United States stems from the Sarbanes-Oxley Act passed in 2002. Among other things, the act (1) established the Public Company Accounting Oversight Board (PCAOB) with powers to regulate many aspects of public accounting and to set standards for audit procedures; (2) prohibited public accounting firms from providing to audit clients certain nonaudit services, such as financial information systems design and implementation and internal audit outsourcing services; and (3) required rotation every 5 years of the lead audit or coordinating partner and the reviewing partner on an audit. All accounting firms that audit companies with publicly traded stock in the United States must register with the PCAOB. These registered public accounting firms numbered nearly 2,400 in early 2012. The act also regulated corporate governance by requiring boards of publicly held companies to appoint an audit committee composed only of “independent” directors, requiring CEOs and chief financial officers (CFOs) to personally sign a statement taking responsibility for their companies’ financial statements, and increasing the criminal penalties for knowingly misreporting financial information. Despite the government’s growing role, the AICPA remains a force in accounting regulation. It regulates entry to the accounting profession by requiring new accountants to (1) have adequate technical knowledge and know how to apply it, and (2) adhere to standards of integrity and independence. To ensure that CPAs have the necessary technical knowledge, the AICPA administers and grades a national examination. The 14-hour, 4-part, computer-based CPA examination covers auditing and attestation, financial accounting and reporting, regulation, and business environment and concepts. Each section of the exam generally has a pass rate of less than 50%, and less than 20% of the candidates pass all four parts in their first attempt. To ensure proper application of a CPA’s technical knowledge, the Public Company Accounting Oversight Board issues generally accepted auditing standards (GAAS). These standards prescribe the minimum steps that an auditor must take in examining the transactions and financial statements and issuing an auditor’s opinion. Following GAAS ensures a reasonable chance of discovering any errors or omissions, intentional or unintentional, in a company’s financial statements. However, in several well-publicized cases in the last decade, auditors were accused of failure to discover some accounting irregularities in companies such as WorldCom, Tyco, Fannie Mae, Washington Mutual, and others.

Professional Ethics Auditors have a professional obligation to truthfully report their findings to the public. This is why we call them public accountants. Meeting this obligation requires accountants to act with integrity and be independent of management’s influence. To help achieve this, members of the AICPA (and many other such organizations globally) must abide by a code of professional conduct. Surveys of public attitudes toward CPAs have consistently ranked the accounting profession as having high ethical standards. However, the corporate scandals in the last decade have caused investors to question some auditors’ integrity and, especially, their independence. This led to additional government regulation of auditor independence and a revision of the AICPA’s independence and integrity standards. Exhibit 1-11 presents the major requirements of those standards. The emphasis on ethics extends beyond public accounting. Various professional accounting organizations and state regulatory bodies have procedures for reviewing behavior alleged to violate codes of professional conduct and imposing appropriate penalties. For example, the Institute of Management Accountants (IMA) and the Association of Government Accountants (AGA) each has a code of ethics that its members must meet to retain their membership. Beyond codes of ethics or codes of conduct, a major influence on the ethical decisions of employees is the “tone at the top.” Complete integrity and outspoken support for ethical standards by senior managers is a great motivator of ethical behavior in any organization. Ultimately, ensuring ethical behavior begins with hiring employees who value ethical issues when making decisions.

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International Auditing and Assurance Standards Board (IAASB) A body established by the International Federation of Accountants that is working to standardize audit regulation around the globe.

Sarbanes-Oxley Act The source of most government regulation of the accounting profession in the United States.

Public Company Accounting Oversight Board (PCAOB) An agency that regulates many aspects of public accounting and sets standards for audit procedures in the United States.

registered public accounting firm An accounting firm that registers with the PCAOB and therefore is allowed to audit companies with publicly traded stock in the United States.

generally accepted auditing standards (GAAS) Standards issued by the Public Company Accounting Oversight Board that prescribe the minimum steps that an auditor must take in examining the transactions and financial statements and issuing an auditor’s opinion.

 OBJECTIVE 9 Evaluate the role of ethics in the accounting process.

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-11 AICPA Code of Professional Conduct, Independence, Integrity, and Objectivity Standards: Excerpted and Paraphrased* I. INDEPENDENCE: The standards indicate that independence will be impaired if

• During the period of the professional engagement a covered member (a) had or was committed to acquire any direct or material indirect financial interest in the client, (b) was a trustee of any trust or executor or administrator of any estate if such trust or estate had or was committed to acquire any direct or material indirect financial interest in the client, (c) had a joint, closely held investment that was material to the covered member, or (d) except as specifically permitted, had any loan to or from the client, any officer or director of the client, or any individual owning 10% or more of the client’s outstanding equity securities or other ownership interests. • During the period of the professional engagement, a partner or professional employee of the firm, his or her immediate family, or any group of such persons acting together owned more than 5% of a client’s outstanding equity securities or other ownership interests. • During the period covered by the financial statements or during the period of the professional engagement, a partner or professional employee of the firm was simultaneously associated with the client as a (a) director, officer, or employee, or in any capacity equivalent to that of a member of management; (b) promoter, underwriter, or voting trustee; or (c) trustee for any pension or profit-sharing trust of the client. II. INTEGRITY AND OBJECTIVITY: The standards indicate that integrity will be impaired by

• Knowing misrepresentations in the preparation of financial statements or records. A member shall be considered to have knowingly misrepresented facts when he or she knowingly (a) makes, or permits or directs another to make, materially false and misleading entries in an entity’s financial statements or records; or (b) fails to correct an entity’s financial statements or records that are materially false and misleading when he or she has the authority to record an entry; or (c) signs, or permits or directs another to sign, a document containing materially false and misleading information. • Conflicts of interest. A conflict of interest may occur if a member performs a professional service for a client or employer and the member or his or her firm has a relationship with another person, entity, product, or service that could, in the member’s professional judgment, be viewed by the client, employer, or other appropriate parties as impairing the member’s objectivity. • Subordination of judgment. A member may not knowingly misrepresent facts or subordinate his or her judgment when performing professional services. *For more details see http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/sec100.aspx. Reprinted by permission of American Institute of CPAs.

High ethical standards by accountants and business executives are also important for a healthy economy. Even if only a few let power and greed drive them to ethically dubious actions, it affects the trust people put in companies. The recent great recession exposed mortgage frauds, investment schemes, and excessive executive compensation. While most companies maintained high ethical standards, enough violated them to create a distrust that negatively affected the entire world economy. Some managers and accountants justify ethical lapses with statements such as “Everyone else is doing it, why shouldn’t I?” However, the vast majority of successful accountants and managers recognize the ethical dimensions of their decisions and act with absolute integrity. Those who do not may get most of the publicity, but there has also been acclaim for those responsible for revealing dishonest accounting, as indicated in the Business First box on page 29.

 OBJECT IVE 10 Recognize career opportunities in accounting, and understand that accounting is important to both for-profit and nonprofit organizations.

Career Opportunities for Accountants Most of you who read this book will not become accountants. You are or will be intelligent consumers of accounting information in your business and personal lives. Because accounting cuts across all management functions, including purchasing, manufacturing, wholesaling, retailing, and a variety of marketing and transportation activities, it provides an excellent background for almost any manager.

CAREER OPPORTUNITIES FOR ACCOUNTANTS

29

BUSINESS FIRST ETHICS, ACCOUNTING, AND WHISTLE-BLOWERS Companies often rely on accountants to safeguard the ethics of the company. Accountants have a special responsibility to ensure that managers act with integrity and that the information disclosed to customers, suppliers, regulators, and the public is accurate. If accountants do not take this responsibility seriously, or if the company ignores the accountants’ reports, bad consequences can follow. Just ask WorldCom or Enron. In both companies, an accountant decided to be a whistle-blower, one who reports wrongdoings to his or her supervisor. The WorldCom and Enron whistle-blowers became Persons of the Year in Time magazine. Cynthia Cooper, Vice President of Internal Audit for WorldCom, told the company’s board of directors that fraudulent accounting entries had turned a $662 million loss into a $2.4 billion profit. This disclosure led to additional discoveries totaling $9 billion in erroneous accounting entries—the largest accounting fraud in history. Cooper was proud of WorldCom and highly committed to its success. Nevertheless, when she and her internal audit team discovered the unethical actions of superiors she admired, she did not hesitate to do the right thing. She saw no joy when CEO Bernie Ebbers and CFO Scott Sullivan were placed in handcuffs and led away. She simply applied what she had learned when she sat in the middle of the front row of seats in her accounting classes at Mississippi State University. Accountants ask hard questions, find the answers, and act with integrity. Being a whistle-blower has not been easy for Cooper. She is a hero to some, a villain to others. However, regardless of the reaction of others, Cooper knows that she just did what any good accountant should do—no matter how painful it is to tell the truth. To read more about Cooper and WorldCom, see her book Extraordinary Circumstances: Journey of a Corporate Whistleblower. The following quote is on Cooper’s Web site (http://cynthiacooper. com/index.html): “At a time when corporate dishonesty

is dominating public attention, … the tone set at the top is critical to fostering an ethical environment in the workplace.” At Enron, Sherron Watkins had a similar experience. An accounting major at the University of Texas at Austin, she started her career at Arthur Andersen. Then she went to work for Enron, eventually working directly for CFO Andrew Fastow. In her job she discovered the offthe-books liabilities that now have become famous. She first wrote a memo to CEO Kenneth Lay and had a personal meeting with him, explaining to him “an elaborate accounting hoax.” Later she discovered that, rather than the hoax being investigated, her report had generated a memo from Enron’s legal counsel titled “Confidential Employee Matter” that included the following: “… how to manage the case with the employee who made the sensitive report…. Texas law does not currently protect corporate whistle-blowers… .” In addition, her boss confiscated her hard drive and demoted her. She now regrets that she did not take the matter to higher levels, but she believed that Mr. Lay would take her allegations seriously. In the end, Watkins proved to be right. Although many at Enron knew what was happening, they ignored it. Watkins’ accounting background made her both able to spot the irregularities and compelled to report them. Another Enron employee, Lynn Brewer, said that “hundreds, perhaps thousands, of people inside the company knew what was going on, and chose to look the other way.” Watkins made the ethical decision and did not simply look the other way. As a result, she is a popular speaker on corporate governance, and Matt Lauer told her story on national television. Sources: A. Ripley, “Whistle-Blower Cynthia Cooper,” Time.com, February 4, 2008; J. Reingold, “The Women of Enron: The Best Revenge,” Fast Company, December 19, 2007; “The Party Crasher,” Time, Jan. 30, 2002 to Jan. 6, 2003, pp. 52–56; “The Night Detective,” Time, Jan. 30, 2002 to Jan. 6, 2003, pp. 45–50; M. Flynn, “Enron Insider Shares Her Insights,” Puget Sound Business Journal, March 7–13, 2003, p. 50; C. Cooper, Extraordinary Circumstances: Journey of a Corporate Whistleblower, Wiley, 2009.

Knowledge of accounting is especially important for finance professionals. After many of the problems in the economy, a BusinessWeek article indicated that “even professional money managers are scared that they don’t know enough accounting.” However, accounting’s value is not restricted to financial managers. Managers who want to move up in the management structure of a company need to know accounting. Surveys have ranked accounting as the most important business school course for future managers. The Web site for the Agonist Learning Center reported that “[a] manager without accounting savvy is like a car driver without eyes. That is why more and more corporates are recruiting CPAs to senior management positions.” Accounting is the language of business, and it is hard to succeed without speaking the language.

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

EXHIBIT 1-12 Common Accounting Career Paths

Business Corporation or Government Agency

Public Accounting Firm

Partner

Chief Executive Officer or Other Major Operating Executive

Promoted to

Promoted to

Manager

Promoted to

Hired as

d re Hi

as

Controller or Treasurer or Chief Financial Officer Promoted to

Senior Accountant

Senior Accountant

Promoted to

Promoted to

Staff Accountant

Staff Accountant

Accounting is an especially good entry position in a company. Because accountants are responsible for collecting and interpreting financial information about the entire company, they develop detailed knowledge about various parts of a company and form close relationships with key decision makers. Senior accountants or controllers in a corporation often become production or marketing executives. Why? Because they have acquired management skills through their dealings with a variety of managers. Others continue in the finance function to become vice presidents of finance or CFOs. Exhibit 1-12 shows various potential career paths for those hired into entry-level accounting positions. Some accountants join a public accounting firm and reach partner after a series of promotions. Others join a business corporation or government agency and proceed up the ladder of success. Many others start in public accounting, even if they do not intend to stay for their entire careers. After being promoted once or twice in public accounting, they shift to an executive position in government or industry. Accounting provides exciting career opportunities. It is a great training ground for future managers and executives. Accountants in public accounting firms perform work for many clients and encounter many different work experiences. Accountants in private companies work with managers throughout the organization and gain a broad understanding of the various functional and product areas. In addition, accountants are well-rewarded. Beginning accountants in large public accounting firms earned between $52,000 and $62,000 a year in 2012—even more with overtime pay. Top partners in the international accounting firms and CFOs at some of the largest corporations earn more than $1 million annually.

A Note on Nonprofit Organizations The major focus of this book is on profit-seeking organizations, such as business firms. However, the fundamental accounting principles also apply to nonprofit organizations. Managers and accountants in hospitals, universities, government agencies, and other nonprofit organizations use financial statements. After all, such organizations must raise and spend money, prepare budgets, and judge financial performance. Some nonprofit organizations, such as the Red Cross or Girl Scouts, are as big as large corporations. Others, such as Bainbridge Island Land Trust

HIGHLIGHTS TO REMEMBER

or Northwest Harvest Food Bank, serve a specific local interest. There is a growing pressure on nonprofit organizations to disclose financial information to the public. In the United States, the Governmental Accounting Standards Board (GASB) regulates disclosures for governmental organizations, and the FASB regulates financial reporting for other nonprofit organizations.

Highlights to Remember

1

Explain how accounting information assists in making decisions. Financial statements provide information to help managers, creditors, and owners of all types of organizations make decisions. The balance sheet (or statement of financial position) provides a “snapshot” of the financial position of an organization at an instant in time. That is, it answers the basic question, “Where are we?” Describe the components of the balance sheet. The balance sheet equation is Assets = Liabilities + Owners’ Equity. This equation must always be in balance. The balance sheet presents the balances of the components of Assets, Liabilities, and Owners’ Equity at a specific point in time. Assets are resources a company owns, liabilities are what it owes, and owners’ equity is the owners’ claims on assets less liabilities. Analyze business transactions and relate them to changes in the balance sheet. Transaction analysis is the heart of accounting. A transaction is any event that both affects the financial position of an entity and can be reliably recorded in monetary terms. For each transaction, an accountant must determine what accounts the transaction affects and the amount to record.

2 3 4

Prepare a balance sheet from transactions data. Accountants can prepare a balance sheet at any time from the detailed transactions that affect the balance sheet equation. The balance sheet reflects the cumulative total of all past transactions. In other words, it is the sum of the beginning balance and the changes caused by the current period transactions for every balance sheet account. However, accountants generally prepare balance sheets only when needed by managers or at the end of each quarter for reporting to the public. Compare the features of sole proprietorships, partnerships, and corporations. Sole proprietorships and partnerships usually have owners who also act as managers. In corporations, shareholders delegate management of the firm to professional managers. The shareholders elect a board of directors, which in turn appoints and monitors the managers. Owners of corporations have limited liability; their personal assets are not at risk. Corporations are the most important form of business ownership because corporations conduct a majority of the world’s business. Identify how the owners’ equity section in a corporate balance sheet differs from that in a sole proprietorship or a partnership. For all three forms of ownership structure, owners’ equity equals total assets less total liabilities. In sole proprietorships or partnerships we usually refer to owners’ equity as capital. The ownership equity of a corporation is usually called stockholders’ equity or shareholders’ equity. It initially takes the form of common stock at par value (or stated value) plus additional paid-in capital.

5 6 7

Explain the regulation of financial reporting, including differences between U.S. GAAP and IFRS. Financial statements throughout the world must adhere to generally accepted accounting principles (GAAP). There are two primary sets of GAAP. Companies in most countries follow the GAAP defined by International Financial Reporting Standards (IFRS), which are set by the International Accounting Standards Board (IASB). In contrast, companies in the United States follow U.S. GAAP. The SEC is responsible for setting U.S. GAAP, and it has delegated this responsibility to the Financial Accounting Standards Board (FASB). The AICPA administers the CPA exam that ensures that professional accountants meet minimum qualification standards. In addition, the Public Company Accounting Oversight Board (PCAOB) regulates the accounting profession and sets auditing standards. Describe auditing and how it enhances the value of financial information. Separation of ownership from management in corporations creates a demand for auditing, a third-party examination of the financial statements. Auditors evaluate a company’s record-keeping system and test specific transactions and account balances to provide assurance that the balances fairly reflect the financial position and performance of the company.

8

Governmental Accounting Standards Board (GASB) The agency that regulates disclosures for governmental organizations in the United States.

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

9

Evaluate the role of ethics in the accounting process. Ethical behavior is critically important in all areas of accounting. If users cannot trust accounting numbers, financial statements will have little value. In public accounting, the value of an audit is directly linked to the credibility of the auditor as an ethical, independent professional who is qualified to evaluate the financial statements of the firm and is also reliably committed to disclosing problems or concerns uncovered in the evaluation. Recognize career opportunities in accounting, and understand that accounting is important to both for-profit and nonprofit organizations. There are excellent career opportunities in accounting, but it is important for all managers, not just accountants, to understand accounting. Accountants and managers in for-profit, nonprofit, and governmental organizations all rely on knowledge of accounting principles in the performance of their duties.

10

Accounting Vocabulary account, p. 11 account payable, p. 13 accounting, p. 3 accounting system, p. 6 additional paid-in capital, p. 20 American Institute of Certified Public Accountants (AICPA), p. 26 annual report, p. 7 assets, p. 9 audit, p. 25 auditor, p. 25 auditor’s opinion, p. 25 balance sheet, p. 9 balance sheet equation, p. 9 board of directors, p. 22 certified public accountant (CPA), p. 25 chief executive officer (CEO), p. 22 closely held, p. 18 common stock, p. 20 common stockholders, p. 21 compound entry, p. 13 corporation, p. 17 creditor, p. 14 entity, p. 10 FASB Financial Standards Codification, p. 23

financial accounting, p. 7 Financial Accounting Standards (U.S. GAAP), p. 23 Financial Accounting Standards Board (FASB), p. 23 Form 10-K, p. 7 generally accepted accounting principles (GAAP), p. 23 generally accepted auditing standards (GAAS), p. 27 Governmental Accounting Standards Board (GASB), p. 31 independent opinion, p. 25 International Accounting Standards Board (IASB), p. 24 International Auditing and Assurance Standards Board (IAASB), p. 27 International Financial Reporting Standards (IFRS), p. 23 inventory, p. 12 liabilities, p. 9 limited liability, p. 17 long-lived asset, p. 11 management accounting, p. 7 net assets, p. 10

notes payable, p. 9 open account, p. 13 owners’ equity, p. 9 paid-in capital, p. 19 paid-in capital in excess of par value, p. 20 par value, p. 20 partnership, p. 17 private accountants, p. 25 privately owned, p. 18 public accountants, p. 25 Public Company Accounting Oversight Board (PCAOB), p. 27 publicly traded stock, p. 7 registered public accounting firm, p. 27 Sarbanes-Oxley Act, p. 27 Securities and Exchange Commission (SEC), p. 7 shareholders’ equity, p. 19 sole proprietorship, p. 17 stated value, p. 20 statement of financial position, p. 9 stock certificate, p. 18 stockholders’ equity, p. 19 transaction, p. 10 unlisted, p. 18 U.S. GAAP, p. 23

Assignment Material The assignment material for each chapter is divided into Questions, Critical Thinking Questions, Exercises, Problems, a Collaborative Learning Exercise, and three

projects on Analyzing and Interpreting Financial Statements. In each chapter, one of these projects involves analyzing Starbucks’ financial statements, allowing students to

ASSIGNMENT MATERIAL

develop a more in-depth understanding of the financial reporting of this one company. The assignment material contains problems based on fictitious companies and problems based on real-life situations. We hope our use of actual companies and news events enhances your interest in accounting. We identify problems based on real companies by highlighting the name in blue. These problems underscore a major objective of this book: to increase your ability to read, understand, and use published financial reports and news articles. In later chapters, these problems provide the principal means of reviewing not only the immediate chapter but also the previous chapters. Questions 1-1 Describe accounting. 1-2 “It’s easier to learn accounting if you avoid real-world examples.” Do you agree? Explain. 1-3 Give three examples of decisions where the decision maker is likely to use financial statements. 1-4 Give three examples of users of financial statements. 1-5 Briefly distinguish between financial accounting and management accounting. 1-6 Describe the balance sheet equation. 1-7 “The balance sheet may be out of balance after some transactions, but it is never out of balance at the end of an accounting period.” Do you agree? Explain. 1-8 “When a company buys inventory for cash, total assets do not change. However, when it buys inventory on open account, total assets increase.” Explain. 1-9 Explain the difference between a note payable and an account payable. 1-10 “Balance sheets for companies in the same industry should look similar except for

the overall size of the accounts. That is, if one company’s property, plant, and equipment is 40% of total assets, you would expect other companies in the industry to also have property, plant, and equipment that totals about 40% of total assets.” Do you agree? Explain. 1-11 List three differences between a corporation and a sole proprietorship or a partnership. 1-12 Explain the meaning of limited liability. 1-13 Why does this book emphasize the corporation instead of the proprietorship or the partnership? 1-14 “International companies with Ltd. or S.A. after their name are essentially the same in organizational form as U.S. companies with Corp. after their name.” Do you agree? Explain. 1-15 “The idea of par value is insignificant.” Explain. 1-16 Explain the relationship between the board of directors and top management of a company. 1-17 How is GAAP set in the United States? How is it set internationally? 1-18 “All companies with stock traded on U.S. stock exchanges must issue financial statements that conform to U.S. GAAP.” Do you agree? Explain. 1-19 What gives value to an audit? 1-20 What is a CPA, and how does someone become one? What is a CA? 1-21 What are the most important ethical standards for accountants? 1-22 Why is understanding accounting important to nonaccountants? 1-23 “The accounting systems described in this book apply to corporations and are not appropriate for nonprofit organizations.” Do you agree? Explain.

Critical Thinking Questions 1-24 Double-Entry Accounting The accounting process in use today is typically called “double-entry” bookkeeping. Discuss the meaning and possible importance of this name.

 OBJECTIVE 3

1-25 Accountants as Historians Critics sometimes refer to accountants as historians and do not mean it kindly. In what sense are accountants historians, and do you believe this is a compliment or a criticism?

 OBJECTIVE 1

1-26 The Corporation Some historians were arguing over the most important innovation in the history of business. Most thought of things and processes such as the railroad, the automobile, the printing press, the telephone, television, or more recently, the computer chip, fiber-optic cable, or even the Internet. One person argued that the really important innovation was the corporation. How would this person argue for this idea? What role did accounting play in the rise of the corporation?

 OBJECTIVE 5

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

 OBJECT IVE 8

1-27 The Auditor’s Opinion In reviewing the annual report of a company in which you might invest, you noted that you did not recognize the name of the audit firm that signed the audit opinion. What questions would this raise in your mind, and how might you resolve them?

Exercises  OBJECT IVE 2

1-28 The Balance Sheet Equation Laredo Company reported total assets of $7 million and total liabilities of $4 million at the end of 20X0. 1. Construct the balance sheet equation for Laredo Company at the end of 20X0 and include the correct amount for owners’ equity. 2. Suppose that during January 20X1 Laredo borrowed $2 million from Wells Fargo Bank. How would this affect Laredo’s assets, liabilities, and owners’ equity?

 OBJECTIVE 3

1-29 Describing Underlying Transactions Radloff’s Furniture Company, which was recently formed, is engaging in some preliminary transactions before beginning full-scale operations for retailing household furnishings. The balances of each item in the company’s accounting equation are given next for May 1 and for each of the next 9 business days.

May 1 2 3 4 5 6 7 8 9 10

Cash

Furniture Inventory

Store Fixtures

Accounts Payable

Owners’ Equity

$ 5,000 11,000 11,000 8,000 8,000 11,000 6,000 4,000 4,000 1,000

$18,000 18,000 18,000 21,000 27,000 27,000 27,000 27,000 26,600 26,600

$2,000 2,000 6,000 6,000 6,000 3,000 9,000 9,000 9,000 9,000

$ 3,000 3,000 3,000 3,000 9,000 9,000 10,000 8,000 7,600 7,600

$22,000 28,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 29,000

State briefly what you think took place on each of the 9 days beginning May 2, assuming that only one transaction occurred each day.

 OBJECT IVE 3

1-30 Describing Underlying Transactions The balances of each item in Melbourne Company’s accounting equation are given next for November 1 and for each of the next 7 business days.

Nov. 1 2 3 4 5 8 9 10

Cash

Computer Inventory

Store Fixtures

Accounts Payable

Owners’ Equity

$5,000 5,000 3,000 3,000 3,000 2,500 1,500 1,500

$ 8,000 8,000 8,000 3,000 10,000 10,000 10,000 10,000

$ 7,500 10,000 10,000 10,000 10,000 10,000 13,500 13,000

$5,500 8,000 8,000 3,000 3,000 2,500 5,000 4,500

$15,000 15,000 13,000 13,000 20,000 20,000 20,000 20,000

State briefly what you think took place on each of the 7 days beginning November 2, assuming that only one transaction occurred each day.

ASSIGNMENT MATERIAL

1-31 Prepare Balance Sheet Jacksonville Corporation’s balance sheet at March 30, 20X1, contained only the following items (arranged here in random order): Cash Notes payable Merchandise inventory Paid-in capital Land

$14,000 10,000 40,000 80,000 14,000

Accounts payable Furniture and fixtures Long-term debt Building Machinery and equipment

 OBJECTIVE 4

$ 8,000 3,000 12,000 24,000 15,000

On March 31, 20X1, these transactions and events took place: 1. 2. 3. 4.

Purchased merchandise on account, $3,000 Sold at cost for $1,000 cash some furniture that was not needed Issued additional capital stock for machinery and equipment valued at $12,000 Purchased land for $25,000, of which $10,000 was paid in cash, the remaining being represented by a 5-year note (long-term debt) 5. The building was valued by professional appraisers at $43,000 Prepare in good form a balance sheet for March 31, 20X1, showing supporting computations for all new amounts. 1-32 Prepare Balance Sheet Southampton Company’s balance sheet at November 29, 20X1, contained only the following items (arranged here in random order):

Paid-in capital Notes payable Cash Accounts payable Merchandise inventory

£190,000 21,000 22,000 16,000 29,000

Machinery and equipment Furniture and fixtures Land Building Long-term debt payable

 OBJECTIVE 4

£ 20,000 8,000 41,000 241,000 134,000

On the following day, November 30, these transactions and events occurred: 1. Purchased machinery and equipment for £13,000, paying £4,000 in cash and signing a 90-day note for the balance 2. Paid £7,000 on accounts payable 3. Sold some land that was not needed for cash of £6,000, which was the Southampton Company’s acquisition cost of the land 4. The remaining land was valued at £240,000 by professional appraisers 5. Issued capital stock as payment for £23,000 of the long-term debt, that is, debt due beyond 1 year Prepare in good form a balance sheet for November 30, 20X1, showing supporting computations for all new amounts. 1-33 Balance Sheet Costco is the third largest retail company in the United States with sales of nearly $90 billion. The company’s balance sheet on August 28, 2011, had total assets of $26,271 million and stockholders’ equity of $12,002 million. 1. Compute Costco’s total liabilities on August 28, 2011. 2. As of August 28, 2011, Costco had issued 434,266,000 shares of common stock with a par value of $.005 per share. Compute the balance in the account, Common Stock, Par Value on Costco’s balance sheet.

 OBJECTIVE 2

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

 OBJECTIVE 6

1-34 Sole Proprietorship and Corporation The Mammal Center pet store is owned by Jon Wilson and has been a sole proprietorship with the following condensed balance sheet on June 30, 20X1:

Assets Cash Accounts receivable Property, plant, and equipment Total assets

Liabilities and Owner’s Equity $15,000 13,000 25,000 $53,000

Accounts payable Bank loan payable Capital––Jon Wilson Total liabilities and owner’s equity

$14,000 9,000 30,000 $53,000

Mr. Wilson decides to incorporate his company on July 1, 20X1, by creating 2,000 shares of common stock, holding 1,000 shares himself, representing his current interest in the store, and selling 1,000 shares to the public for cash of $30 per share. Each share has a $1 par value. Prepare a balance sheet for The Mammal Center immediately after incorporation.

Problems  OBJECTIVES 3, 4

1-35 Analysis of Transactions Use the format of Exhibit 1-2 (p. 12) to analyze the following transactions for April of Marymount Services, Inc. Then prepare a balance sheet as of April 30, 20X1. Marymount Services was founded on April 1. 1. 2. 3. 4. 5. 6. 7. 8.

 OBJECT IVES 3, 4

Issued 1,000 shares of common stock for cash, $60,000; use a single Paid-in-Capital account. Issued 500 shares of common stock for equipment, $20,000 Borrowed cash, signing a note payable for $35,000 Purchased equipment for cash, $33,000 Purchased office furniture on account, $10,000 Disbursed cash on account (to reduce the account payable), $4,000 Sold equipment for cash, $8,000, an amount equal to its cost Discovered that the most prominent competitor in the area was bankrupt and was closing its doors on April 30

1-36 Analysis of Transactions Consider the following January transactions: 1. On January 1, 20X1, three persons, James, Bosh, and Wade, formed JBW Corporation. JBW is a wholesale distributor of electronic equipment. The company issued 10,000 shares of common stock ($1 par value) to each of the three investors for $10 cash per share. Use two stockholders’ equity accounts: Capital Stock (at par) and Additional Paid-in Capital. 2. JBW acquired merchandise inventory of $75,000 for cash. 3. JBW acquired merchandise inventory of $85,000 on open account. 4. JBW returned for full credit unsatisfactory merchandise that cost $11,000 in transaction 3. 5. JBW acquired equipment of $40,000 for a cash down payment of $10,000, plus a 3-month promissory note of $30,000. 6. As a favor, JBW sells equipment of $4,000 to a business neighbor for cash. The equipment had cost $4,000. 7. JBW pays $16,000 on the account described in transaction 3. 8. JBW buys merchandise inventory of $100,000. The company pays one-half of the amount in cash, and owes one-half on open account. 9. Wade sells one-half of his common stock to Nowitzki for $13 per share. Required 1. By using a format similar to Exhibit 1-2, prepare an analysis showing the effects of the January transactions on the financial position of JBW Corporation. 2. Prepare a balance sheet as of January 31, 20X1.

ASSIGNMENT MATERIAL

1-37 Analysis of Transactions Suppose you began a business as a wholesaler of auto parts in Lisbon. The following events have occurred (the symbol € represents the euro, the European currency):

 OBJECTIVES 3, 4

1. On March 1, 20X1, you invested €80,000 cash in your new sole proprietorship, which you call Autopartes Lisbon. 2. You acquired €10,000 inventory for cash. 3. You acquired €8,000 inventory on open account. 4. You acquired equipment for €15,000 in exchange for a €5,000 cash down payment and a €10,000 promissory note. 5. A large retail store, which you had hoped would be a big customer, discontinued operations. 6. You take tires home for your family car. Autopartes Lisbon’s inventory carried the tires at €600. (Regard this as taking part of your capital out of Autopartes Lisbon.) 7. Parts that cost €300 in transaction 2 were damaged in shipment. You returned them and obtained a full cash refund. 8. Parts that cost €800 in transaction 3 were the wrong size. You returned them and obtained parts of the correct size in exchange. 9. Parts that cost €500 in transaction 3 had an unacceptable quality. You returned them and obtained full credit on your account. 10. You paid €2,000 on the promissory note. 11. You use your personal cash savings of €5,000 to acquire some equipment for Autopartes Lisbon. You consider this to be an additional investment in your business. 12. You paid €3,000 on open account. 13. Two transmission manufacturers who are suppliers for Autopartes Lisbon announced a 7% rise in prices, effective in 60 days. 14. You use your personal cash savings of €1,000 to acquire a new TV set for your family. 15. You exchange equipment that cost €4,000 in transaction 4 with another wholesaler. However, the equipment received, which is almost new, is smaller and is worth only €1,500. Therefore, the other wholesaler also pays you €2,500 in cash. (You recognize no gain or loss on this transaction.) Required 1. By using Exhibit 1-2 (p. 12) as a guide, prepare an analysis of Autopartes Lisbon’s transactions for March. Confine your analysis to the effects on the financial position of Autopartes Lisbon. 2. Prepare a balance sheet for Autopartes Lisbon as of March 31, 20X1. 1-38 Analysis of Transactions Leida Cruz, a recent law school graduate, was penniless on December 25, 20X0. 1. On December 26, Cruz inherited an enormous sum of money. 2. On December 27, she placed $60,000 in a business checking account for her unincorporated law practice. 3. On December 28, she purchased a home for a down payment of $120,000 plus a home mortgage payable of $230,000. 4. On December 28, Cruz agreed to rent a law office. She provided a $1,000 cash damage deposit (from her business cash), which will be fully refundable when she vacates the premises. This deposit is a business asset. She will make rental payments in advance on the first business day of each month. (The first payment of $700 is not to be made until January 2, 20X1.) 5. On December 28, Cruz purchased a computer for her law practice for $2,000 cash, plus a $3,000 promissory note due in 90 days. 6. On December 28, she purchased legal supplies for $1,000 on open account. 7. On December 28, Cruz purchased office furniture for her practice for $4,000 cash. 8. On December 29, Cruz hired a legal assistant receptionist for $380 per week. She was to report to work on January 2. 9. On December 30, Cruz’s law practice lent $3,000 cash in return for a 1-year note from Sam Whitman, a local candy store owner. Whitman had indicated that he would spread the news about the new lawyer.

 OBJECTIVES 3, 4

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CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

Required 1. Use the format demonstrated in Exhibit 1-2 (p. 12) to analyze the transactions of Leida Cruz, lawyer. To avoid crowding, put your numbers in thousands of dollars. Do not restrict yourself to the account titles in Exhibit 1-2. 2. Prepare a balance sheet as of December 31, 20X0.

 OBJECT IVES 3, 4

1-39 Analysis of Transactions Walgreen Company is a well-known drugstore chain. A condensed balance sheet for August 31, 2011, follows ($ in millions): Assets

Liabilities and Stockholders’ Equity

Cash Inventories Property and other assets Total

$ 1,556 8,044

Accounts payable Other liabilities

$ 4,810 7,797

17,854 $27,454

Stockholders’ equity Total

14,847 $27,454

Use a format similar to Exhibit 1-2 (p. 12) to analyze the following transactions for the first two days of September ($ amounts are in millions). Then prepare a balance sheet as of September 2. 1. Issued 1,000,000 shares of common stock to employees for cash, $30 2. Issued 1,500,000 shares of common stock for the acquisition of $42 of special equipment from a supplier 3. Borrowed cash, signing a note payable for $13 4. Purchased equipment for cash, $18 5. Purchased inventories on account, $89 6. Disbursed cash on account (to reduce the accounts payable), $35 7. Sold for $2 cash some display equipment at original cost of $2

 OBJECTIVES 3, 4

1-40 Analysis of Transactions Nike, Inc., had the following condensed balance sheet on May 31, 2011 ($ in millions): Assets

Liabilities and Stockholders’ Equity

Cash Inventories

$ 1,955 2,715

Total liabilities Stockholders’ equity

Property, plant, and equipment Other assets Total assets

2,115 8,213 $14,998

Total liabilities and stockholders’ equity

$ 5,155 9,843 $14,998

Suppose the following transactions occurred during the first 3 days of June ($ in millions): 1. Nike acquired inventories for cash, $28. 2. Nike acquired inventories on open account, $19. 3. Nike returned for full credit, $4, some unsatisfactory shoes that it acquired on open account in May. 4. Nike acquired $14 of equipment for a cash down payment of $5, plus a 2-year promissory note of $9. 5. To encourage wider displays, Nike sold some special store equipment to New York area stores for $40 cash. The equipment had cost $40 in the preceding month. 6. Clint Eastwood produced, directed, and starred in a movie. As a favor to a Nike executive, he agreed to display Nike shoes in a basketball scene. Nike paid no fee. 7. Nike disbursed cash to reduce accounts payable, $16. 8. Nike borrowed cash from a bank, $50. 9. Nike sold additional common stock for cash to new investors, $90. 10. The president of the company sold 5,000 shares of his personal holdings of Nike stock through his stockbroker.

ASSIGNMENT MATERIAL

Required 1. By using a format similar to Exhibit 1-2 (p. 12), prepare an analysis showing the effects of the June transactions on the financial position of Nike. 2. Prepare a balance sheet as of June 3. 1-41 Prepare Balance Sheet Jennifer Grant is a realtor. She buys and sells properties on her own account, and she also earns commissions as a real estate agent for buyers and sellers. Her business was organized on November 24, 20X1, as a sole proprietorship. Grant also owns her own personal residence. Consider the following on November 30, 20X1:

 OBJECTIVE 4

1. Grant owes $85,000 on a mortgage on some undeveloped land, which her business acquired for a total price of $170,000. 2. Grant had spent $18,000 cash for a Century 21 real estate franchise. Century 21 is a national affiliation of independent real estate brokers. This franchise is an asset. 3. Grant owes $100,000 on a personal mortgage on her residence, which she acquired on November 20, 20X3, for a total price of $180,000. 4. Grant owes $3,800 on a personal charge account with Nordstrom’s. 5. Grant acquired business furniture for $17,000 on November 25, for $6,000 on open account, plus $11,000 of business cash. On November 26, Grant sold a $1,000 business chair for $1,000 to her next-door business neighbor for cash. 6. On November 28, Grant hired her first employee, Aaron Rubenstein. He was to begin work on December 1. Grant was pleased because Rubenstein was one of the best real estate salesmen in the area. On November 29, Rubenstein was killed in an automobile accident. 7. Grant’s balance at November 30 in her business checking account after all transactions was $6,000. Prepare a balance sheet as of November 30, 20X1, for Jennifer Grant, realtor. 1-42 Bank Balance Sheet Consider the following simplified balance sheet accounts of Wells Fargo & Company as of September 30, 2011 (in billions of $): Assets

 OBJECTIVE 2

Liabilities and Stockholders’ Equity

Cash Investment securities

$

18 398

Loans receivable Other assets Total assets

740 149 $1,305

Deposits Other liabilities Total liabilities Stockholders’ equity Total liabilities and stockholders’ equity

$ 895 271 1,166 139 $1,305

This balance sheet illustrates how Wells Fargo gathers and uses money. More than 87% of the total assets are in the form of investments and loans, and more than 68% of the total liabilities and stockholders’ equity are in the form of deposits, a major liability. That is, financial institutions such as Wells Fargo are in the business of raising funds from depositors and, in turn, lending those funds to businesses, homeowners, and others. The stockholders’ equity is usually small in comparison with the deposits (less than 11% of total liabilities and stockholders’ equity in this case). 1. 2. 3. 4.

What Wells Fargo accounts would be affected if you deposited $1,000? Why are deposits listed as liabilities? What accounts would be affected if the bank loaned Jens Olafson $75,000 for home renovations? What accounts would be affected if Isabel Valdez withdrew $5,000 from her savings account?

1-43 Airline Balance Sheet Air France-KLM S.A. is an international airline headquartered in France with stock traded in both Paris and Amsterdam. It has more than 400 aircraft and more than 100,000 employees. On September 30, 2011, Air France-KLM’s noncash assets were €24,860 million. Total assets were €27,739 million, and total liabilities were €21,512 million. The symbol € represents the euro, the European currency.

 OBJECTIVE 2

39

40

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

1. Compute the following: a. Air France-KLM’s cash on September 30, 2011. b. Air France-KLM’s stockholders’ equity on September 30, 2011. 2. Explain the easiest way to determine Air France-KLM’s total liabilities and stockholders’ equity from the information given in this problem.

 OBJECTIVE 4

1-44 Prepare Balance Sheet United Technologies Corporation provides a broad range of high-technology products and support services to the building systems and aerospace industries. Those products include Pratt & Whitney aircraft engines, Carrier heating and air conditioning equipment, Otis elevators, and Sikorsky helicopters. United Technologies’ September 30, 2011, balance sheet included the following items ($ in millions): Fixed assets Accounts payable Common stock Cash Total stockholders’ equity Long-term debt Total assets Inventories Other assets Other stockholders’ equity Other liabilities

$ 6,137 5,597 13,330 ? ? 9,501 61,948 8,617 41,228 ? 22,935

Prepare a condensed balance sheet, including amounts for 1. Cash. 2. Total Stockholders’ Equity. 3. Other Stockholders’ Equity.

 OBJECT IVE 4

1-45 Prepare Balance Sheet Macy’s, Inc., headquartered in both Cincinnati and New York, operates more than 840 stores in 45 states under the Macy’s and Bloomingdale’s names. Its balance sheet on October 29, 2011, contained the following items ($ in millions): Long-term debt Cash Total liabilities Shareholders’ equity Inventories Merchandise accounts payable Property, plant, and equipment Other assets Other liabilities Total assets

$ 6,151 ? ? ? 7,158 3,576 8,423 5,585 6,684 22,263

Prepare a condensed balance sheet, including amounts for 1. Cash. What do you think of its relative size? 2. Total Liabilities. 3. Shareholders’ Equity.

 OBJECT IVE 5

1-46 Partnership and Corporation El-Hashem Partners is a partnership started by two brothers, Muhab and Ghassan El-Hashem. Each has an equal share of the total owners’ equity of $90,000. There is only one asset, a rental

ASSIGNMENT MATERIAL

house listed at $350,000, and one liability, a mortgage loan of $260,000. The date is June 15, 20X0. The El-Hashem brothers are considering changing their partnership to El-Hashem Corporation by issuing each brother 1,000 shares of common stock. 1. Prepare a balance sheet for the current partnership. 2. Prepare a balance sheet if the brothers form a corporation. The par value of each share of common stock is $1.

 OBJECTIVE 6

1-47 Presenting Paid-in Capital Consider excerpts from two balance sheets (amounts in millions): Citigroup Common stock ($.01 par value; authorized shares: 60 billion), issued shares 29,224,016,234 at December 31, 2010

$

Additional paid-in capital

292

101,024

IBM Common stock, par value $.20 per share and additional paid-in capital

$ 45,418

Shares authorized: 4,687,500,000 Shares issued: 2,161,800,054

1. How would the presentation of Citigroup stockholders’ equity accounts be affected if the company issued 500 million more shares for $25 cash per share? 2. How would the presentation of IBM’s stockholders’ equity accounts be affected if the company issued 1 million more shares for $180 cash per share? Be specific. 1-48 Presenting Paid-in Capital Chevron, the petroleum exploration, production, refining, and marketing company, presented the following in its September 30, 2011, balance sheet. Common stock—$.75 par value, 2,442,676,580 shares issued Capital in excess of par value

 OBJECTIVE 6

? $15,110,000,000

What amount should be shown on the common stock line? What was the average price per share paid by the original investors for the Chevron common stock? How do your answers compare with the $100 market price of the stock in early 2012? Comment briefly. 1-49 Presenting Paid-in Capital Honda Motor Company is the largest producer of motorcycles in the world, as well as a major auto manufacturer. Honda included the following items in its 2011 balance sheet (in millions of Japanese Yen, ¥): Common stock—authorized 7,086,000,000 shares; issued 1,811,428,430 shares Capital surplus*

¥ 86,067 172,529

*Honda uses the term “capital surplus” instead of the preferred terms, additional paid-in capital or capital in excess of par value.

1. What is the par value of Honda’s common stock? 2. What was the average price per share paid by the original investors for the Honda common stock? 3. How do your answers compare with the ¥3,000 market price of the stock at the end of fiscal 2011? Comment briefly.

 OBJECTIVE 6

41

42

CHAPTER 1 • ACCOUNTING: THE LANGUAGE OF BUSINESS

 OBJECT IVES 7, 8

1-50 Audit Opinion and IFRS Versus U.S. GAAP Carrefour, the French supermarket company, included the following paragraph from its auditor in its 2011 annual report: In our opinion, the consolidated financial statements give a true and fair view of the assets and liabilities and of the financial position of the Group as of 31 December 2011 and of the results of its operations for the year then ended in accordance with the IFRS as adopted by the European Union. Safeway the U.S. supermarket chain had a similar paragraph in its 2011 annual report: In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Safeway Inc. and subsidiaries as of January 3, 2012, . . . and the results of their operations and their cash flows for [the year] ended January 3, 2012, in conformity with accounting principles generally accepted in the United States of America. Explain what is meant by “in accordance with the IFRS as adopted by the European Union” and “in conformity with accounting principles generally accepted in the United States of America.”

 OBJECT IVE 8

1-51 Board of Directors and Audit Committee Examine the 2011 annual report of General Mills, maker of cereals such as Cheerios, Betty Crocker cake mixes, Progresso soups, and other foods (http://phx.corporate-ir.net/phoenix. zhtml?c=74271&p=irol-reportsannual). Turn to the listing of General Mills’ Board of Directors on page 16 of the annual report. 1. How many board members does General Mills have? How many of them are General Mills executives? 2. How many of the nonexecutive directors are executives or retired executives of other companies? How many are academics? What other positions are represented on the board? How does the background of board members influence their ability to carry out the responsibilities of the board? 3. How many members of the General Mills’ Board of Directors are on the audit committee? Are any audit committee members also General Mills executives? Why would investors want to know the composition of the audit committee?

 OBJECT IVE 9

1-52 Accounting and Ethics A 2009 survey by Clemson University researchers examined the ethics concerns of chief executive officers of 300 large- and mid-sized corporations in the United States. Their number one concern was improper accounting practices. Recognizing the importance of ethics in accounting, professional associations for both internal accountants and external auditors place much emphasis on their standards of ethical conduct. Discuss why maintaining a reputation for ethical conduct is important for (1) accountants within an organization, and (2) external auditors. What can accountants do to foster a reputation for high ethical standards and conduct?

Collaborative Learning Exercise  OBJECT IVES 3, 4

1-53 Understanding Transactions Form groups of three to five students each. Each group should choose one of the companies included in the Dow Jones Industrial Average (Exhibit 1-1), and find its most recent balance sheet. (You might try the company’s home page on the Internet or the SEC’s EDGAR database at www.sec.gov/edgar.shtml.) Ignore much of the detail on the balance sheet, focusing on the following accounts: Cash, Inventory, Equipment, Notes Payable, Accounts Payable, and Total Stockholders’ Equity. Exact names may vary slightly across companies. Divide the following six assumed transactions among the members of the group: 1. 2. 3. 4. 5. 6.

Sold 1 million shares of common stock for a total of $9 million cash (ignore par value) Bought inventory for cash of $3 million Borrowed $5 million from the bank, receiving the $5 million in cash Bought inventory for $7 million on open account Paid $4 million to suppliers for inventory bought on open account Bought equipment for $9 million cash

ASSIGNMENT MATERIAL

Required 1. The student responsible for each transaction should explain to the group how the transaction would affect the company’s balance sheet, using the accounts listed earlier. 2. By using the most recent published balance sheet as a starting point, prepare a balance sheet for the company, assuming the preceding six transactions are the only transactions since the date of the latest balance sheet.

Analyzing and Interpreting Financial Statements 1-54 Financial Statement Research Select the financial statements of any company, and focus on the balance sheet.

 OBJECTIVE 2

1. Identify the amount of cash (including cash equivalents, if any) shown on the most recent balance sheet. 2. What were the total assets shown on the most recent balance sheet, and the total liabilities plus stockholders’ equity? How do these two amounts compare? 3. Identify (a) total liabilities, and (b) total stockholders’ equity. (Assume that all items on the right side of the balance sheet that are not explicitly listed as stockholders’ equity are liabilities.) Compare the size of the liabilities to stockholders’ equity, and comment on the comparison. Write the company’s accounting equation, as of the most recent balance sheet date, by filling in the dollar amounts. 1-55 Analyzing Starbucks’ Financial Statements This and similar problems in each succeeding chapter focus on the financial statements of Starbucks Corporation. Starbucks is a worldwide retailer of specialty coffees. As you solve each of these homework problems, you will gradually strengthen your understanding of Starbucks’ complete financial statements. You can find these statements either on the investor relations page of Starbuck’s Web site (http://investor.starbucks.com) or via the SEC’s EDGAR database (www. sec.gov/edgar.shtml). Refer to Starbucks’ balance sheet and answer the following questions:

 OBJECTIVE 2

1. How much cash did Starbucks have on October 2, 2011? (Include cash equivalents as part of cash.) 2. List the account titles and amounts from Starbucks’ balance sheet that are accounts that were discussed in this chapter. 3. Write the company’s accounting equation as of October 2, 2011, by filling in the dollar amounts: Assets = Liabilities + Stockholders’ equity. 1-56 Analyzing Financial Statements Using the Internet: Cisco Locate the Cisco annual report. Do this by searching for “Cisco Systems,” clicking Investor Relations under About Cisco, and opening Annual Reports under the Financial Reporting tab. Then click Open Printable Report in the box for the most recent annual report. Answer the following questions concerning Cisco: 1. Select Letter to Shareholders from the menu. Is the message optimistic? 2. Select Business – General from the menu. When was the company founded? What is its focus? 3. Now find Cisco’s balance sheet under Part II – Financial Statements. What are Cisco’s Total Assets, Total Liabilities, and Total Shareholders’ Equity? 4. How much are Cisco’s inventories? Have they increased or decreased in the last year? Do you think that change is good or bad? 5. Select the Report of Independent Registered Public Accounting Firm, which is also under the Financial Statements tab. Who is responsible for the preparation, integrity, and fair presentation of Cisco’s financial statements? What is the auditor’s responsibility? 6. Find Cisco’s list of members of its board of directors near the end of the report. How many directors are there? How many are Cisco executives? How many are academics? How many directors are on the audit committee?

 OBJECTIVES 2, 7

43

2

Measuring Income to Assess Performance IT IS HARD TO MISS “Big G” cereals when you walk down the breakfast-food aisle in a grocery store. Both children and adults recognize Cheerios, Wheaties, Lucky Charms, and other Big G cereals, all made by General Mills. Cadwallander Washburn certainly did not envision today’s General Mills when he built his first flour mill on the banks of the Mississippi River in Minneapolis in 1866. Little did he know that in 2013 his company’s products would satisfy customers worldwide. General Mills is not just a breakfast-food company. Its products include convenience foods such as Old El Paso Mexican foods, Progresso soups, Green Giant vegetables, and “helper” casseroles; baking supplies such as Betty Crocker cake mixes, Bisquick baking mixes, and Gold Medal flour; snack foods such as Fruit Roll-Ups, Pop Secret microwave popcorn, and Nature Valley granola bars; and refrigerated items such as Pillsbury frozen breakfast pastries, Pillsbury frozen waffles, and Totino’s frozen pizza, not to mention Yoplait yogurt, Häagen-Dazs ice cream, and many more. In addition, General Mills is a leading supplier to the foodservice and commercial baking industries, so you may eat General Mills products when you dine away from home. For General Mills to have grown so large and to have so many products, management must have been successful. Although companies cannot measure success with any single metric, in this chapter we see one important measure of a company’s success—its profitability. How can we measure the overall performance of a company such as General Mills and its management? When owners and investors want to evaluate performance, they often use measures of profitability for the entire company as well as profitability measures related to segments of the company. The most common measure of profitability for a company is its net income—its sales less its expenses—which is the topic of this chapter. In 2011, General Mills had sales of almost $14.9 billion and expenses of about $13.1 billion, leaving income of approximately $1.8 billion or

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Explain how accountants measure income. 2 Determine when a company should record revenue from a sale. 3 Use the concept of matching to record the expenses for a period. 4 Prepare an income statement and show how it is related to a balance sheet.

5 Account for cash dividends and prepare a statement of stockholders’ equity. 6 Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividendpayout ratio. 7 Explain how the conceptual framework guides the standard setting process and how accounting

regulators trade off relevance and faithful representation in setting accounting standards. 8 Explain how the following concepts affect financial statements: entity, going concern, materiality, stable monetary unit, periodicity, and reliability.

12.1% of sales. This means that, on average, when you buy a General Mills product for which the store paid $1.00, General Mills ends up with 12.1¢ of income. It takes a lot of boxes of cereal, bags of flour, cans of soup, and cartons of yogurt to add up to $14.9 billion in sales. To achieve this level of sales, General Mills sells its products in more than 100 countries around the world. In addition, General Mills pays a lot of employees and farmers, uses many buildings and machines, purchases much advertising and other promotion services, and incurs many other expenses—all of which add up to $13.1 billion of expenses. It takes skillful management to oversee such a large operation, and accounting reports are an important tool used by management. It also takes huge amounts of capital to support such operations, and General Mills has raised part of that capital by selling more than 750 million ownership shares to the public. These owners also want financial reports on General Mills’ operations to help them evaluate their decision to invest in the firm. Until now you may have thought of a trip to the grocery store as nothing more than a chance to replenish your food supply. However, from now on you can think about the accounting systems that record sales for the items you buy and identify the expenses required to bring these products to you. It might not make your trip more enjoyable, but it will make it more enlightening.

Most people recognize General Mills for the “Big G” breakfast cereals such as those shown here. However, the company has many other products on the shelves of nearly every grocer y store. General Mills’ income statement, described in this chapter, summarizes the profits the company makes on cereals together with all its other products.

Investors in General Mills eagerly await reports about the company’s annual income. Investors care about the price of their shares, and stock prices generally reflect investors’ expectations about income. However, actual reported income often differs from what investors expected, and stock prices react to the difference between expectations and reported income. For example, on September 21, 2011, General Mills issued a press release reporting first quarter income of $.64 per share. This amount was identical to that reported a year earlier, but it beat analysts’ expectations of $.62 per share. What happened to General Mills’ stock price? After the announcement, General Mills’ stock price jumped by 2.5%. Although other company, industry, or general economic news that day also influenced the stock price, the unexpectedly positive earnings announcement certainly contributed to the increased stock price.



45

46

CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

EXHIBIT 2-1 Relationship Between Stock Price and Net Income for General Mills Corporation $45.00 $40.00

$3.00 Stock Price per Share ($) Net Income per Share ($)

$2.50

$35.00 $30.00 Stock Price per Share ($) $25.00

$2.00

Net Income per Share ($)

$1.50 $20.00 $15.00

$1.00

$10.00 $0.50 $5.00 $0.00

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20

$0.00

Although income and stock prices tend to move in the same direction, the relationship is not perfect. Look at Exhibit 2-1, which shows the income and stock price of General Mills for the last 20 years. The left vertical axis and the brown bars represent the stock price in dollars per share, and the right vertical axis and purple bars are the net income in dollars per share. Overall, the company has experienced increasing trends in both net income per share and stock price per share. However, as is true for most companies, the correlation between net income and stock price for General Mills is not perfect. Company-specific, industryspecific, or general economic conditions can produce deviations in the trend. For example, note that in 2002, General Mills had a small increase in stock price over 2001 but the 2002 net income per share was significantly lower. In the annual report General Mills explained that the acquisition of Pillsbury on October 31, 2001, significantly affected the financial condition and results in fiscal 2002. Also notice that, in 2009, General Mills experienced a very modest increase in net income per share, while the stock price decreased substantially. This may be attributable to the overall market decline that was still evident at General Mills’ May 31, 2009, fiscal year end. You can see that income—the topic of this chapter—is a key measure of performance and value.

 OBJECT IVE 1 Explain how accountants measure income.

Introduction to Income Measurement Measuring income is important to everyone, from individuals to businesses, because we all need to know how well we are doing economically. Income is one metric we use to evaluate economic performance. We can think of income like the number on the scoreboard that tells how well a team is performing. However, measuring income is not as easy as measuring the number of runs scored in a baseball game. Most people regard income as a measure of the increase in the “wealth” of an entity over a period of time. However, companies can measure wealth and income in various ways. To allow decision makers and investors to compare the performance of one company with that of another, generally accepted accounting principles specify certain measurement rules that all companies must follow in measuring net income. While measurement details differ somewhat between the two sets of GAAP, IFRS

INTRODUCTION TO INCOME MEASUREMENT

47

and U.S. GAAP, the basic principles covered in this chapter apply to both. Let’s begin by looking at the period over which accountants measure income.

Operating Cycle The activities in most companies follow a repeating operating cycle. The operating cycle, also known as the cash cycle, begins with the acquisition of goods and services in exchange for cash. The company then sells products to customers, who in turn pay for their purchases with cash. This brings us back to the beginning of the cycle. Consider a retail company such as Wal-Mart:

Starts with Cash $100,000

Buys Merchandise

Merchandise Inventory $100,000

Sells Merchandise

operating cycle (cash cycle) The time elapsing between the acquisition of goods and services in exchange for cash and the subsequent sale of products to customers, who in turn pay for their purchases with cash.

Customers Owe $160,000

Collects Cash

The box for the amounts owed to the entity by customers is larger than the other two boxes because the company’s objective is to sell its goods at a price higher than it paid for them. The amount by which the selling price exceeds expenses is profit or income.

The Accounting Time Period Because it is difficult to accurately measure the success of an ongoing operation, the only way to be certain of a business’s success is to close its doors, sell all its assets, pay all liabilities, and return any leftover cash to the owner. Actually, in the 1400s, Venetian merchant traders did exactly that for each and every voyage. Investors provided cash to buy merchandise and pay the crew, and after the voyage the traders paid the investors whatever profits were generated on the voyage. Because that system would not be feasible for companies today, we need to measure performance over time periods shorter than the life of the company. In the United States, the calendar year is the most popular time period for measuring income. However, about 35% of publicly traded U.S. companies use a fiscal year that differs from the calendar year. Established purely for accounting purposes, the fiscal year does not necessarily end on December 31. Many companies choose the end of calendar-year quarters (March 31, June 30, and September 30) as their fiscal year end. For example, Microsoft ends its fiscal year on June 30, and The Walt Disney Company uses September 30. Some companies select the low point in annual business activity as their fiscal year-end date. For example, Wal-Mart and Macy’s use a fiscal year ending on January 31 after completing holiday and postholiday sales. General Mills ends its fiscal year on the last Sunday in May, a low point in the company’s operating cycle. In Japan, many companies, including such well-known companies as Sony, Toyota, Honda, and Toshiba, use a March 31 year end to coincide with that of the Japanese government. Users of financial statements would like information more than once a year. They want to know how well the business is doing at least each quarter. Therefore, companies also prepare financial statements for these interim periods—periods of less than a year. The SEC requires companies with publicly traded securities to officially file financial statements every quarter. However, in some countries such as those in the European Union, authorities require only semiannual statements.

fiscal year The year established for accounting purposes, which may differ from the calendar year.

interim periods The time spans established for accounting purposes that are less than a year.

48

CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Revenues and Expenses

revenue (sales, sales revenue) The increase in net assets resulting from selling products or services. Revenues increase owners’ equity.

expenses Decreases in net assets as a result of consuming or giving up resources in the process of providing products or services to a customer. Expenses decrease owners’ equity.

income (profits, earnings) The excess of revenues over expenses.

retained earnings (retained income) Total cumulative owners’ equity generated by income or profits.

Now let’s see how accountants measure income. Revenues and expenses are the key components. These terms apply to the inflows and outflows of assets that occur during a business’s operating cycle. Companies obtain assets by selling products or services and use assets in producing and delivering those products or services. When they sell products or services, they record revenue (sometimes called sales or sales revenue), which is the increase in net assets resulting from selling products or services. Revenues increase owners’ equity. In contrast, expenses are decreases in net assets as a result of consuming or giving up resources in the process of providing products or services to a customer. Expenses decrease owners’ equity. Income (also known as profits or earnings) is the excess of revenues over expenses. If expenses exceed revenues, we call it a loss. Revenues arise when General Mills ships a carton of Cheerios to Safeway. Expenses arise when General Mills uses oats, sugar, and other materials to produce the Cheerios and when it pays the costs of delivering them to Safeway. General Mills earns income when the revenues exceed the costs to produce and deliver the Cheerios. The total cumulative owners’ equity generated by income or profits is called retained earnings or retained income. You can learn the importance of income or earnings from the Business First box on page 50. Consider again the Biwheels Company we examined in Chapter 1. Exhibit 2-2 is almost a direct reproduction of Exhibit 1-2, which summarized the nine transactions of Hector Lopez’s business. However, the company has now been incorporated with multiple stockholders, and the owners’ equity account is no longer Hector Lopez, Capital. In Exhibit 2-2, it is Stockholders’ Equity, which contains both Paid-in Capital and Retained Earnings.

EXHIBIT 2-2 Biwheels Company Analysis of Transactions for January 2, 20X2, to January 12, 20X2 (in $) Assets Cash

(1) Initial investment

+400,000

=

(2) Loan from bank

+100,000

= +100,000

(3) Acquire store equipment for cash

−15,000

(4) Acquire inventory for cash

−120,000

(5) Acquire inventory on credit (6) Acquire inventory for cash plus credit

−10,000

(7) Sale of equipment

+1,000

(8) Return of inventory acquired on January 6 (9) Payment to creditor Balance January 12, 20X2

+

Store Equipment =

Liabilities

Description of Transactions

+

Merchandise Inventory

=

+

Accounts Payable

Stockholders’ Equity

+

Paid-in Capital +400,000

+15,000 = +120,000

=

+10,000

=

+10,000

=

+20,000

+30,000

−1,000 =

−800 −4,000

352,000 +

Note Payable

+

159,200

+

−800

=

−4,000

14,000 =

¯˚˚˚˚˚˘˚˚˚˚˚˙ 525,200

=

100,000 +

25,200 +

400,000

¯˚˚˚˚˘˚˚˚˚˙ 525,200

Retained + Earnings

EXHIBIT 2-3 Biwheels Company Analysis of Transactions for January 20X2 (in $) Assets Description of Transactions

Cash

=

Accounts Merchandise Prepaid + Receivable + Inventory + Rent +

(1)–(9) See Exhibit 2-2 Balance, January 12, 20X2 352,000 (10a) Sales on open account (inflow of assets)

+

159,200

+

Store Equipment

14,000

+160,000

=

Liabilities Note Payable

+

= 100,000 +

+

Stockholders’ Equity

Accounts Payable +

Paid-in Capital

25,200 +

400,000

+

=

Retained Earnings

+160,000 (Sales Revenue)

(10b) Cost of merchandise inventory sold (outflow of assets)

−100,000

(11) Collect accounts receivable

+5,000

(12) Pay rent in advance

−6,000

=

−5,000

=

(13) Recognize expiration of rental services

+6,000

=

−2,000

=

−2,000 (Rent Expense)

=

−100 (Depreciation Expense)

(14) Recognize expiration of equipment services

Balance January 31, 20X2

−100

351,000 +

155,000

−100,000 (Cost of Goods Sold Expense)

+

59,200 583,100

+

4,000 +

13,900

= 100,000 +

25,200

+ 400,000

583,100

+

57,900

49

50

CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

BUSINESS FIRST E A R N I N G S A N D E A R N I N G S E X P E C TAT I O N S Earnings are a critical measure of company performance, and investors watch earnings carefully. Almost every day the financial press reports on current and prospective earnings. A focus for both investors and the press is “consensus earnings forecasts.” A major source of consensus forecasts is Zacks Investment Research (another source is Thomson Reuters I/B/E/S). A large number of Wall Street analysts follow the stocks of any major corporation, and Zacks gathers the analysts’ forecasts and publishes a continually updated average of the forecasts. These are important inputs to investors, even to sophisticated investors such as mutual fund managers. When a company announces its actual earnings, the press inevitably compares it with the consensus analysts’ forecast. Any difference between the forecast and actual earnings is called an “earnings surprise.” Most companies try to keep their earnings surprises to a minimum by providing guidance to analysts about what to expect. Consider Apple’s earnings announcements during 2010. The following table shows the Zacks consensus earnings forecast each quarter compared with the actual earnings: Quarter

Reporting Actual Consensus Earnings Earnings Date Earnings Earnings Surprise Surprise %

Q1/2011 1/18/11

$6.43

$5.38

$1.05

19.52

Q2/2011 4/20/11

$6.40

$5.34

$1.06

19.85

Q3/2011 7/19/11

$7.79

$5.81

$1.98

34.08

Q4/2011 10/18/11 $7.05

$7.30

−$0.25

−3.42

Meeting earnings expectations is important. Investors derive information from earnings reports, and

accounts receivable (trade receivables, receivables) Amounts owed to a company by customers as a result of the company’s delivering goods or services and extending credit in the ordinary course of business.

when the results surprise them, stock prices generally react. You might expect that a positive earnings surprise would lead to an increase in stock price and that a negative earnings surprise would lead to a stock price decrease. Apple met expectations in three of the four quarters of fiscal 2011. The positive earnings surprises in the second and third quarters (April and July) contributed to a 3.1% and 2.8% increase in stock price, respectively, in the two days following the announcements. Apple’s failure to meet the consensus estimate in the fourth quarter (a negative 3.42% surprise) was followed by a 6.38% decrease in the stock price over the two days following the announcement. This seemingly disproportionate stock price decline is partly attributable to the fact that this was the first time in more than 6 years that Apple missed the quarterly analysts’ earnings estimate. The first quarter seems to defy the simple expectation that a positive earnings surprise will be followed by an increase in stock price. Despite the 19.52% positive earnings surprise in January, Apple’s stock fell 2.34% in the two days following the earnings announcement. Why might this occur? Other company, industry, and general economic news occurring around the time of the earnings announcement can also influence the stock price.

Sources: http://www.zacks.com/stock/news/46168/Record+1Q+for+Apple; http://www. zacks.com/stock/news/51710/Apple+Fires+All+Cylinders+in+Q2; http://www.zacks.com/ stock/news/57331/Apple+Crushes+Estimates; http://www.zacks.com/stock/news/62929/ Apple+Struggles+in+4Q; http://investing.businessweek.com/research/stocks/earnings/ earnings.asp?ticker=APPL:US.

Now consider some additional transactions that are shown in Exhibit 2-3, a continuation of Exhibit 2-2. Suppose Biwheels’ sales for the entire month of January total $160,000 on open account. The cost to Biwheels of the inventory sold is $100,000. Selling on open account creates an account receivable. Accounts receivable (sometimes called trade receivables or simply receivables) are amounts owed to a company by customers as a result of the company’s delivering goods or services to the customers and extending credit in the ordinary course of business. Thus, the January sales increase Biwheels’ Accounts Receivable account by $160,000. Delivering merchandise to customers reduces its Merchandise Inventory account by $100,000. Note that we record the January sales and other transactions illustrated here as summarized transactions. The company’s sales, purchases of inventory, collections from customers, or disbursements to suppliers do not take place all at once. Actual accounting systems record every sale at the time of sale using a cash register, a scanner, or some other data entry device, and then summarize the data over some period of time, such as the month of January for our example.

INTRODUCTION TO INCOME MEASUREMENT

The accounting for the summarized sales transaction has two phases, a revenue phase (10a) and an expense phase (10b): Assets

=

Liabilities

+

Stockholders’ Equity

Accounts + Merchandise Receivable Inventory (10a) Sales on open account

+160,000

(10b) Cost of merchandise inventory sold

−100,000

Retained Earnings =

+160,000 (Sales Revenue)

=

−100,000 (Cost of Goods Sold Expense)

To understand this transaction, think of it as two steps occurring simultaneously in the balance sheet equation: an inflow of assets in the form of accounts receivable (10a) in exchange for an outflow of assets in the form of merchandise inventory (10b). This exchange of assets does not affect liabilities, so to keep the equation in balance, stockholders’ equity must increase by $60,000 [that is, $160,000 (Sales Revenue) − $100,000 (Cost of Goods Sold expense)]. Note that cost of goods sold expense (also called cost of sales or cost of revenue) is the original acquisition cost of the inventory that a company sells to customers during the reporting period. As entry 10a shows, we record revenue from sales as an increase in the asset Accounts Receivable and an increase in Retained Earnings. In contrast, in entry 10b we record the cost of goods sold expense as a decrease in the asset Merchandise Inventory and a decrease in Retained Earnings. You can see that revenues are positive entries to the Retained Earnings account in the stockholders’ equity section of the balance sheet, and expenses are negative entries to Retained Earnings. We illustrate these relationships as follows, where the arrows show the components of the various accounts: Assets = Liabilities + Stockholders’ equity

Assets = Liabilities + Paid-in capital + Retained earnings

Accounts receivable + Inventory = Liabilities + Paid-in capital + Revenues - Expenses 160,000 + (-100,000) = 0 + 0 + (+160,000) - (+100,000) Increase in assets

60,000 = Increase in retained earnings

60,000

The ultimate purpose of sales is not to generate accounts receivable. Rather, Biwheels wants to collect these receivables in cash on a timely basis. The company may receive some cash shortly after a credit sale, and some customers may delay payments for long periods. Suppose Biwheels collects $5,000 of its $160,000 of accounts receivable during January. This summary transaction, call it transaction 11, increases Cash and decreases Accounts Receivable. It does not affect Retained Earnings.

Assets Cash (11) Collect accounts receivable +5,000

+

= Liabilities +

Accounts + Merchandise = Receivable Inventory −5,000

Stockholders’ Equity Retained Earnings

=

We next consider how accountants decide when to record revenues in the books and how this affects measures of income.

cost of goods sold (cost of sales, cost of revenue) The original acquisition cost of the inventory that a company sells to customers during the reporting period.

51

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Measuring Income Accrual Basis and Cash Basis accrual basis Accounting method in which accountants record revenue as a company earns it and expenses as the company incurs them—regardless of when cash changes hands.

cash basis Accounting method that recognizes revenue when a company receives cash and recognizes expenses when it pays cash.

 OBJECTIVE 2 Determine when a company should record revenue from a sale.

revenue recognition Criteria for determining whether to record revenue in the financial statements of a given accounting period. To be recognized, revenues must be earned and realized or realizable.

There are two popular methods of measuring income, the accrual basis and the cash basis. Under the accrual basis, accountants record revenue as it is earned and record expenses as they are incurred, regardless of when cash changes hands. In contrast, the cash basis recognizes revenue when a company receives cash and recognizes expenses when it pays cash. For many years, accountants debated the merits of accrual-basis versus cash-basis accounting. Supporters of the accrual basis maintained that the cash basis ignores activities that increase or decrease assets other than cash. Supporters of the cash basis pointed out that a company, no matter how well it seems to be doing, can go bankrupt if it does not manage its cash properly. Who is correct? In the end, the debate has been declared a draw. Companies prepare their income statements on an accrual basis, and they also prepare a separate statement of cash flows (described in Chapter 5). Although both cash and accrual bases have their merits, the accrual basis has the advantage of presenting a more complete summary of the entity’s value-producing activities. It recognizes revenues as companies earn them and matches costs to revenues. We illustrated this accrual process in our analysis of the sale on open account in transaction 10. We recognized revenue although Biwheels received no cash, and we recorded an expense although, at the time of the sale, Biwheels paid no cash. Let’s now take a look at some of the specifics of the accrual basis.

Recognition of Revenues When accountants measure income on an accrual basis, they use a set of revenue recognition criteria, which determine whether to record revenue in the financial statements of a given accounting period. To be recognized under U.S. GAAP, revenues must ordinarily satisfy two criteria: 1. They must be earned. A company earns revenues when it has completed all (or substantially all) that it has promised to a customer. Typically, this involves the delivery of goods or services to a customer. 2. They must be realized or realizable. Revenues are realized when a company receives cash or claims to cash in exchange for goods or services. A “claim to cash” usually means a customer’s promise to pay. Revenues are realizable when the company receives assets that are readily convertible into known amounts of cash or claims to cash. To recognize revenue on the basis of a promise to pay, the company must be relatively certain that it will receive the cash. IFRS also contains criteria that companies must satisfy in order to recognize revenue. While the wording of the criteria differs, IFRS guidance typically results in revenue recognition occurring at the same time and in the same amount as does U.S. GAAP. The FASB and IASB are actively working on a revision of the rules for revenue recognition. The revision would clarify the principles for recognizing revenue and develop a common revenue standard for U.S. GAAP and IFRS. While final guidance is yet to be issued, changes are likely in the near future. Revenue recognition for most retail companies, such as Wal-Mart, Safeway, and McDonald’s, is straightforward. Such companies earn and realize revenue at the point of sale— when a customer makes a full payment by cash, check, or credit card and takes possession of the goods. Other companies may earn and realize revenue at times other than the point of sale. However, even in such cases, they do not recognize revenue until both earning and realization are complete. Consider the following examples: • The Wall Street Journal receives prepaid subscriptions. The Wall Street Journal realizes revenue when it receives the subscription, but it does not earn the revenue until delivery of each issue. • A dealer in oriental rugs lets a potential customer take a rug home on a trial basis. The customer has possession of the goods, but the dealer records no revenue until the customer formally promises to accept and pay for the rug. We elaborate further on revenue recognition in Chapter 6.

MEASURING INCOME

53

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Suppose you are examining the 2013 financial statements of a new theater company. The theater sells a subscription series that allows patrons to attend all nine of its productions that occur monthly from September through May. During August and September, the company sold 1,000 subscriptions for the 2013–2014 season at $270 each and collected the cash. How much revenue from these subscriptions did the theater recognize in its financial statements for the year ended December 31, 2013?

Answer At December 31, 2013, the theater has produced only four out of nine productions, so the company has earned only four-ninths of the total, or $120,000. Its total cash collections are $270,000. While the theater has realized all $270,000, it has earned only $120,000. Therefore, it recognizes and records only $120,000 of revenue in 2013.

Matching We have seen how to recognize revenues on the accrual basis. What about expenses? There are two types of expenses in every accounting period: (1) those linked to the revenues earned that period, and (2) those linked to the time period itself. Expenses that are naturally linked to revenues are product costs. Examples include cost of goods sold and sales commissions. If there are no revenues, there is no cost of goods sold or sales commissions. When do we recognize product costs? Accountants match such expenses to the revenues they help generate. We recognize and record expenses in the same period that we recognize the related revenues, a process called matching. While the concept of matching is straightforward, it can be difficult to link some expenses directly to specific revenues. Rent and many administrative expenses are examples. These expenses support a company’s operations for a given period, so we call them period costs. We record period costs as expenses in the period in which the company incurs them. For example, rent expense arises because of the passage of time, regardless of the level of sales. Therefore, rent is an example of a period cost. Consider a General Mills warehouse. The rent expense for the month of May gives General Mills the right to use the building for the month. General Mills records the entire rent expense in May, regardless of whether May’s sales are high or low. To help us match expenses with revenues, we record purchases of some goods or services as assets because we want to match their costs with the revenues in future periods. For example, we might buy inventory that we will not sell until a future period. By recording this inventory first as an asset and then expensing it when we sell the item, we match the cost of the inventory with the revenue from the sale of the inventory. Another example is rent paid in advance. Suppose a firm pays annual rent of $12,000 on January 1 for the use of a building. We increase an asset account, Prepaid Rent, by $12,000 because we have not yet used the rental services. Each month we reduce the Prepaid Rent account by $1,000 and increase Rent Expense by $1,000, acknowledging that we use up the prepaid rent asset as we occupy the building.

Applying Matching To focus on matching, assume that Biwheels Company has only two expenses other than the cost of goods sold: rent expense and depreciation expense. Rent is $2,000 per month, payable quarterly in advance. Biwheels makes a payment of $6,000 for store rent, covering January, February, and March of 20X2. (Assume that Biwheels made this initial payment on January 16, although rent is commonly paid at the beginning of the rental period.) This is transaction 12 in Exhibit 2-3. The rent payment gives the company the right to use the store facilities for the months of January, February, and March. The use of the facilities constitutes a future benefit, so Biwheels records the $6,000 in an asset account, Prepaid Rent. Transaction 12, the rent payment, has no effect on stockholders’ equity in the balance sheet equation. Biwheels simply exchanges one asset, Cash, for another, Prepaid Rent:

Assets (12) Pay rent in advance

=

Cash

+ Prepaid Rent =

−6,000

+6,000

=

Liabilities

+ Stockholders’ Equity

 OBJECTIVE 3 Use the concept of matching to record the expenses for a period.

product costs Costs that are linked with revenues and are charged as expenses when the related revenue is recognized.

matching The recording of expenses in the same time period that we recognize the related revenues.

period costs Expenses supporting a company’s operations for a given period. We record these expenses in the time period in which the company incurs them.

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

At the end of January, Biwheels records transaction 13. It recognizes that the company has used 1 month (one-third of the total) of the rental services. Therefore, Biwheels reduces Prepaid Rent by $2,000. It also reduces the Retained Earnings account in stockholders’ equity by $2,000 as Rent Expense for January. Assets Cash (13) Recognize expiration of rental services

depreciation The systematic allocation of the acquisition cost of long-lived assets to the expense accounts of the particular accounting periods that benefit from the use of the assets.

+

=

Liabilities

+ Stockholders’ Equity

Prepaid Rent

=

Retained Earnings

−2,000

=

−2,000 (Rent Expense)

This recognition of rent expense means that Biwheels has used $2,000 of the asset, Prepaid Rent, in the conduct of operations during January. That $2,000 in rent was a period cost for January, and Biwheels recognized it as an expense at the end of that period. Prepaid rent of $4,000 remains an asset on January 31. Why? The $4,000 is a future benefit for Biwheels. Suppose Biwheels had not prepaid the rent. It would then have to pay $2,000 in both February and March for rent. Therefore, the prepayment means that future cash outflows will be $4,000 less than they would have been without the prepayment. The same matching concept that underlies the accounting for prepaid rent applies to depreciation, which is the systematic allocation of the acquisition cost of long-lived assets to the expense accounts of the particular accounting periods that benefit from the use of the assets. Depreciation applies to physical assets that a company owns, such as buildings, equipment, furniture, and fixtures, that the company expects to use for multiple periods. (Land is not subject to depreciation because it does not deteriorate over time.) In both of these examples, prepaid rent and depreciation, the business purchases an asset that gradually wears out or is used. As a company uses an asset, it transfers more and more of the asset’s original cost from the asset account to an expense account. The main difference between depreciation and prepaid rent is the length of time before the asset loses its usefulness. Buildings, equipment, and furniture remain useful for many years; prepaid rent and other prepaid expenses usually expire within a year. Transaction 14 in Exhibit 2-3 records the depreciation expense for the Biwheels equipment. A portion of the original cost of $14,000 becomes depreciation expense in each month of the equipment’s useful life. Assume that Biwheels will use the equipment for 140 months. Under the matching concept, the depreciation expense for January is ($14,000 ÷ 140 months), or $100 per month:

Assets

=

Store Equipment = (14) Recognize expiration of equipment services

−100

=

Liabilities

+

Stockholders’ Equity Retained Earnings −100 (Depreciation Expense)

In this transaction, Biwheels decreases the asset account, Store Equipment, and also decreases the stockholders’ equity account, Retained Earnings. Transactions 13 and 14 highlight the general concept of expense under the accrual basis. We can account for the purchase and use of goods and services—for example, inventories, rent, and equipment—in two basic steps: (1) the acquisition of the assets (transactions 3, 4, 5, and 6 in Exhibit 2-2 and transaction 12 in Exhibit 2-3), and (2) the expiration of the assets as expenses (transactions 10b, 13, and 14 in Exhibit 2-3). As these examples show, when a company uses the services represented by prepaid expenses and long-lived assets, it decreases both total assets and stockholders’ equity. Remember that expense accounts are deductions from stockholders’ equity.

MEASURING INCOME

Recognition of Expired Assets You can think of assets such as inventory, prepaid rent, and equipment as costs that a company stores and carries forward to future accounting periods and then records as expenses when it uses them. For inventory, we record the expense when the company sells the item and recognizes revenue from the sale. For rent, we recognize the expense in the period to which the rent applies. For equipment, we split the total cost of the long-lived asset into smaller pieces and recognize one piece of that total cost as an expense in each of the accounting periods that benefits from the use of the equipment. In summary, inventory costs are product costs that accountants match to the revenues they help generate. Rent is a period cost that accountants record in the period it benefits. Because equipment benefits many periods, accountants spread its cost over those periods as depreciation expense:

Acquisition

Expiration

Assets (Unexpired Costs Such as Inventory, Prepaid Rent, Equipment)

Expenses (Such as Cost of Goods Sold, Rent, Depreciation, Other Expenses)

Instantaneously or Eventually Become

The analysis of the inventory, rent, and depreciation transactions in Exhibits 2-2 and 2-3 distinguishes between acquisition and expiration. Biwheels recorded inventory, rent, and equipment as assets when it acquired them. The unexpired costs of inventory, prepaid rent, and equipment then remain assets until used. When Biwheels uses them, they become expenses. What happens if Biwheels acquires assets and uses them right away? For example, companies often acquire services such as advertising and use them almost immediately. Conceptually, these costs are assets until the company uses them, at which time it recognizes them as expenses. For example, suppose General Mills purchased newspaper advertising for Wheaties for $1,000 cash. To abide by the acquisition–expiration sequence, we could analyze the transaction in two phases as in alternative 1 that follows:

Assets Transaction

Cash

= Liabilities +

Other Prepaid + Assets + Advertising =

Stockholders’ Equity Paid-in Capital +

Retained Earnings

Alternative 1: Two Phases Phase (a) Prepay for advertising

−1,000

Phase (b) Use advertising

+1,000

=

−1,000

=

−1,000 (Advertising Expense)

=

−1,000 (Advertising Expense)

Alternative 2: One Phase Phases (a) and (b) together

−1,000

In practice, however, if a company uses prepaid advertising and other similar services in the same accounting period that it acquires them, accountants may not bother recording them as assets. Instead, accountants frequently use the recording shortcut shown in alternative 2.

55

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Although alternative 1 is technically correct, alternative 2 does not misstate the company’s financial position as long as the advertising prepayment and the use of the advertising occur in the same accounting period. Although this chapter focuses on the income statement, it is important to realize that the income statement is really just a way of explaining changes between one accounting period’s balance sheet and the next period’s balance sheet. It shows how the performance of management moved the company from its beginning financial position to its end-of-the-period position. The balance sheet equation shows revenue and expense items as components of stockholders’ equity. The income statement simply collects all these changes in stockholders’ equity for the accounting period and combines them in one place.

(1) Assets (A) = Liabilities (L) + Stockholders’ equity (SE)

(2) Assets

= Liabilities

+ Paid-in capital + Retained Earnings

(3) Assets

= Liabilities

+ Paid-in capital + Cumulative - Cumulative Revenues Expenses

Revenue and expense accounts are nothing more than subdivisions of stockholders’ equity— temporary stockholders’ equity accounts. Their purpose is to summarize the dollar volume of sales and the various expenses so we can measure income. The analysis of each transaction in Exhibits 2-2 and 2-3 illustrates the dual nature of the balance sheet equation, which must always remain in balance. If the items affected are all on one side of the equation, the total amount added must equal the total amount subtracted on that side. If the items affected are on opposite sides of the equation, then equal amounts are simultaneously added or subtracted on each side. The striking feature of the balance sheet equation is its universal applicability. No one has ever conceived a transaction, no matter how complex, that we cannot analyze via the equation. Business leaders and accountants employ the balance sheet equation constantly to be sure they understand the effects of business transactions they are planning.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S You are examining the financial statements of a company that started in business on January 1, 2013, and rented an office for $4,000 per month. It paid 8 months of rent in advance for a total of $32,000. During January, the company earned no revenue. How much rent expense do you expect to see on the company’s financial statements for January?

Answer Rent expense is $4,000 for January. Companies charge rent expense in the period to which the rental applies. It is a period cost that becomes an expense when the company uses the space rented, regardless of the level of sales for that period.

The Income Statement  OBJECTIVE 4 Prepare an income statement and show how it is related to a balance sheet.

You have now seen how companies record revenues and expenses and use them to measure income. We next consider how companies report revenues, expenses, and income in their financial statements. Chapter 1 introduced the balance sheet as a snapshot-in-time summary of a company’s financial status. To report a company’s performance as measured by income during the accounting period, we need another basic financial statement, the income statement. An income statement (also called statement of earnings or statement of operations) is a report of all revenues and expenses pertaining to a specific time period. Net income (or net earnings) is the famous “bottom line” on an income statement—the remainder after deducting all expenses from revenues.

THE INCOME STATEMENT

Sales revenue Deduct expenses Cost of goods sold Rent Depreciation Total expenses Net income

$160,000

EXHIBIT 2-4 Biwheels Company Income Statement, for the Month Ended January 31, 20X2

$100,000 2,000 100 102,100 $ 57,900

Look back at Exhibit 2-3 and notice that four of the accounting events (transactions 10a, 10b, 13, and 14) affect Biwheels Company’s Retained Earnings account through recognition of sales revenue, cost of goods sold expense, rent expense, and depreciation expense. Exhibit 2-4 shows how an income statement arranges these transactions to arrive at a net income of $57,900. Because the income statement measures performance over a period of time, whether it be a month, a quarter, or a year, it must always indicate the exact period covered. In Exhibit 2-4, the Biwheels income statement clearly shows it covers the month ended January 31, 20X2. Public companies in much of the world publish income statements quarterly. In some countries, companies publish only semiannual or annual statements. Worldwide, most companies prepare such statements monthly or weekly for internal management purposes. Some CEOs even ask for a daily income statement that summarizes the income of the previous day. Decision makers both inside and outside the company use income statements to assess the company’s performance over a span of time. The income statement shows how the entity’s operations for the period have increased net assets (that is, assets minus liabilities) through revenues and decreased net assets through expenses. Net income measures the amount by which the increase in net assets (revenues) exceeds the decrease in net assets (expenses). Of course, expenses could exceed revenues, in which case the company experiences a net loss. Net income or net loss is one measure of the wealth an entity creates or loses from its operations during the accounting period. Tracking net income or loss from period to period and examining changes in its components helps investors and other decision makers evaluate the success of the period’s operations. For example, General Mills reported 2011 net earnings of $1,798.3 million, 17.5% higher than in 2010. Management explained that this increase was due in part to an almost 2% increase in sales, half of which was attributable to physical sales volume and half to small price increases, and in part to a favorable change in product mix. The majority of the increase in net earnings resulted from cost-saving initiatives, marketing spending efficiencies, and accounting adjustments that decreased some expense categories and reduced taxes. The CEO and chairman of the board of directors indicated: “We are generally pleased with our 2011 sales and profit results, which met the key targets we set for the year and represent performance consistent with our long-term growth model.”

Relationship Between the Income Statement and Balance Sheet The income statement is the major link between two balance sheets:

Balance Sheet Balance Sheet Balance Sheet Balance Sheet December 31 January 31 February 28 March 31 20X1 20X2 20X2 20X2 Income Income Income Statement Statement Statement for January for February for March Time Time Income Statement for Quarter Ended March 31, 20X2

57

income statement (statement of earnings, statement of operations) A report of all revenues and expenses pertaining to a specific time period.

net income (net earnings) The remainder after deducting all expenses from revenues.

net loss The difference between revenues and expenses when expenses exceed revenues.

58

CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

You can think of income statements as filling in the gaps between balance sheets. The balance sheets show the financial position of the company at discrete points in time, and the income statements explain the changes that have taken place between those points. For example, the balance sheet for Biwheels Company on January 2, 20X2, showed assets of $500,000 and, to balance the equation, liabilities of $100,000 plus stockholders’ equity of $400,000. There were no retained earnings. The January transactions analyzed in Exhibit 2-3 showed revenues of $160,000 and expenses of $102,100 recorded in the Retained Earnings account. The income statement in Exhibit 2-4 displays these revenues and expenses for the month of January and shows the resulting net income of $57,900. On the balance sheet on January 31, 20X2, the stockholders’ equity account, Retained Earnings, will be $57,900 greater than on January 2.

Ethics, Depreciation, and Net Income Sometimes measuring net income can cause ethical dilemmas for accountants. In Chapter 1, we learned about the ethical standards of accountants. It is usually easy to avoid conduct that is clearly unethical. However, ethical standards and accounting standards often leave room for individual interpretation and judgment. The most difficult ethical situations arise when there is strong pressure to take an action in the gray area between ethical and unethical or when two ethical standards conflict. Because net income is so important in measuring managerial performance, occasionally managers put pressure on accountants to report higher revenues or lower expenses than is appropriate. In the economic downturns of the last decade, authorities accused many companies of manipulating their income to make results look better than they actually were. For example, in 2002 authorities accused executives at Enron and WorldCom of manipulating net income, Enron by recognizing excess revenues and WorldCom by omitting required expenses. In 2004, the SEC accused insurance giant AIG of issuing “materially falsified financial statements … to paint a falsely rosy picture of [the company’s] financial results to analysts and investors.” The largest bankruptcy in U.S. history followed the collapse of Lehman Brothers in 2008. The company reported record profits in January 2008 and was bankrupt by the following September. Many believe that the collapse and bankruptcy of Lehman Brothers fueled the U.S. financial and economic crisis. Accounting scandals are not limited to U.S. companies. Early in 2009, the SEC charged an Indian company, Satyam Computer Services, with fraudulently overstating the company’s revenue, income, and cash balances by more than $1 billion over a 5-year period. One area that requires judgment, and therefore leaves room for ethical conflicts, is depreciation. Suppose you are an accountant for an airline with $15 billion of new airplanes. Management wants to depreciate the airplanes over 30 years—leading to depreciation of $500  million per year. You discover that most airlines depreciate similar airplanes over 15 years, which would mean $1 billion of annual depreciation. Management argues that airplanes such as these will physically last at least 30 years, and there is no reason not to use them for the entire 30-year period. You believe that technological change is likely to make them obsolete in 15 years, but such technological improvements are not assured and may not occur. With depreciation of $500 million, before-tax income for the company would be $400 million, so increasing depreciation to $1 billion will put the company in a loss position. If this happens, banks might ask for repayment of loans and force the company into bankruptcy. Should you prepare an income statement with $500 million of depreciation or insist on the larger $1 billion depreciation expense? There is no obviously right answer to this question. The important point is that you recognize the ethical dimensions of this problem and weigh them when forming your opinion. The company might be in dire straits if you refuse to prepare an income statement with the $500 million of depreciation. However, if you truly believe that it is not proper to depreciate the airplanes over 30 years, you cannot ethically prepare an income statement with only $500 million of depreciation. Could management be right and you be wrong about the proper depreciation expense? Is management trying to influence its net income by manipulating its depreciation expense? Accountants must assert their judgments in cases such as this. Recognizing the ethical issues involved is an important part of making those judgments.

THE INCOME STATEMENT

Summary Problem for Your Review PROBLEM Biwheels’ transactions for January were analyzed in Exhibits 2-2 and 2-3. The balance sheet at January 31, 20X2, follows: Biwheels Company Balance Sheet, January 31, 20X2 Liabilities and Stockholders’ Equity

Assets Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment

Total assets

$351,000 155,000 59,200

4,000 13,900

$583,100

Liabilities: Note payable Accounts payable Total liabilities Stockholders’ equity: Paid-in capital Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

$100,000 25,200 125,200 $400,000 57,900 457,900 $583,100

The following transactions occurred during February: 15. Collections of accounts receivable, $130,000. 16. Payments of accounts payable, $15,000. 17. Acquisitions of inventory included $80,000 on open account and $10,000 acquired in exchange for cash. 18. Sales of merchandise for $176,000, of which $125,000 was on open account and $51,000 was for cash. The merchandise sold was carried in inventory at a cost of $110,000. 19. Recognition of rent expense for February. 20. Recognition of depreciation expense for February. 21. Borrowing of $10,000 from the bank, which Biwheels used to buy $10,000 of store equipment on February 28.

Required 1. Prepare an analysis of transactions, employing the balance sheet equation approach demonstrated in Exhibit 2-3. 2. Prepare a balance sheet as of February 28, 20X2, and an income statement for the month of February.

SOLUTION 1. The analysis of transactions is in Exhibit 2-5. All transactions are straightforward extensions or repetitions of the January transactions. Notice that some of these are summary transactions. For example, Biwheels made sales to many different customers; the $176,000 is the sum of all these sales. Likewise, Biwheels acquired the $90,000 of inventory from several suppliers at different times during February. 2. Exhibit 2-6 contains the balance sheet and Exhibit 2-7 the income statement, which were both described earlier. Notice that the balance sheet lists the ending balances in all the accounts in Exhibit 2-5. The income statement summarizes the revenue and expense entries in the Retained Earnings account.

59

60

EXHIBIT 2-5 Biwheels Company Analysis of Transactions for February 20X2 (in $) Assets Description of Transactions Balance, January 31, 20X2 (15) Collect accounts receivable

Cash

Accounts Merchandise + Receivable + Inventory +

351,000 + +130,000

(16) Pay accounts payable

−15,000

(17) Acquire inventory on open account and for cash

−10,000

(18a) Sales on open account and for cash

+51,000

=

155,000

+

59,200

+

Prepaid Rent 4,000

Store + Equipment = +

13,900

=

Liabilities Notes Payable

+

100,000 +

+

Accounts Payable + 25,200

+

Stockholders’ Equity Paid-in Capital

+

Retained Earnings

400,000

+

57,900

−130,000

+90,000 +125,000

=

−15,000

=

+80,000

=

+176,000 (Sales Revenue)

(18b) Cost of inventory sold

−110,000

=

−110,000 (Cost of Goods Sold Expense)

(19) Recognize expiration of rental services

−2,000

=

−2,000 (Rent Expense)

(20) Recognize expiration of equipment services (depreciation)

−100

=

−100 (Depreciation Expense)

(21a) Borrow from bank

+10,000

(21b) Purchase store equipment

−10,000

Balance February 28, 20X2

507,000

=

+

150,000

+

39,200 722,000

+

2,000

+

+10,000

=

23,800

=

+10,000

110,000

+

90,200

+

400,000

722,000

121,800

ACCOUNTING FOR DIVIDENDS AND RETAINED EARNINGS

Assets Cash

Liabilities and Stockholders’ Equity $507,000

Accounts receivable

150,000

Merchandise inventory

39,200

Prepaid rent

2,000

Store equipment

23,800

Liabilities: Notes payable Accounts payable

$722,000

90,200

$200,200

EXHIBIT 2-6 Biwheels Company Balance Sheet, February 28, 20X2 (before declaring dividends)

Stockholders’ equity: Paid-in capital Retained earnings

Total assets

$110,000

61

$400,000 121,800

Total liabilities and stockholders’ equity

Sales revenue

521,800 $722,000

$176,000

Income Statement, for the Month Ended February 28, 20X2

Deduct expenses Cost of goods sold

$110,000

Rent

EXHIBIT 2-7 Biwheels Company

2,000

Depreciation

100

112,100 $ 63,900

Net income

Accounting for Dividends and Retained Earnings Recall that companies record revenues and expenses for a particular time period in Retained Earnings, a stockholders’ equity account. Because net income is the excess of revenues over expenses, the Retained Earnings account increases by the amount of net income reported during the period. If expenses exceed revenues, the Retained Earnings account decreases by the amount of the period’s net loss.

OBJECTIVE 5 Account for cash dividends and prepare a statement of stockholders’ equity.

Cash Dividends Another decrease in the Retained Earnings account arises from cash dividends, distributions of cash to stockholders. Corporations pay out cash dividends to stockholders to provide a return on the stockholders’ investment in the corporation. The ability to pay dividends is fundamentally a result of profitable operations. Retained earnings increase as profits accumulate, and they decrease as a company pays dividends. Although cash dividends decrease retained earnings, they are not expenses like rent and depreciation. Therefore, unlike rent and depreciation expense, we do not deduct dividends from revenues on the income statement. Why? Because dividends are not directly linked to the generation of revenue or the cost of operating activities. Rather, they are voluntary distributions of cash to stockholders, not a cost of doing business. Assume that on February 28, Biwheels declared and disbursed cash dividends of $50,000 to stockholders. We can analyze this transaction (22) as follows: Assets Cash (22) Declaration and payment of cash dividends

= Liabilities =

−50,000 =

+ Stockholders’ Equity Retained Earnings −50,000 (Dividends)

Cash dividends distribute some of the company’s assets (cash) to shareholders, thus reducing the economic value of their remaining interest in Biwheels. Of course, companies must have sufficient cash on hand to pay cash dividends.

cash dividends Distributions of cash to stockholders that reduce retained earnings.

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Transaction 22 presents the declaration and payment of a dividend as a single transaction. However, corporations usually approach dividend distributions in steps. The board of directors declares—announces its intention to pay—a dividend on one date (declaration date), payable to those stockholders on record as owning the stock on a second date (record date), and actually pays the dividend on a third date (payment date). The dividend amount reduces retained earnings and is recorded as a liability on the declaration date. On the payment date, both the dividend liability and cash decrease. We discuss dividends in more detail in Chapter 10. Not all companies pay dividends. As of November 2012, eBay had never paid dividends. Microsoft and McDonald’s paid no dividends during their early, high-growth years, but today they pay regular dividends. Starbucks paid its first dividend in 2010. As a successful company grows, the Retained Earnings account can increase rapidly if the company pays no dividends or dividends that are significantly less than its net income. Retained Earnings can easily be the largest stockholders’ equity account. Its balance is the cumulative, lifetime earnings of the company less its cumulative, lifetime losses and dividends. For example, at the end of fiscal 2011, General Mills had retained earnings of $9,191.3 million, whereas paid-in capital was only $1,395.3 million.

Retained Earnings and Cash The existence of retained earnings and cash enable a board of directors to declare a cash dividend. However, Cash and Retained Earnings are two entirely separate accounts, sharing no necessary relationship. Consider the following illustration: Step 1. Assume an opening balance sheet of Cash

$100

Paid-in capital

$100

Step 2. Purchase inventory for $50 cash. The balance sheet now reads Cash Inventory Total assets

$ 50 Paid-in capital

$100

50 $100

Step 3. Now sell the inventory for $80 cash. This results in a Retained Earnings balance of $30, $80 in Revenues minus $50 in Cost of Goods Sold. Cash

$130

Paid-in capital Retained earnings Total owners’ equity

$100 30 $130

At this stage, the balance in Retained Earnings seems to be directly linked to the cash increase of $30. It is, but do not think that retained earnings is a claim against the cash specifically. Remember, it is a claim against total assets. We can clarify this relationship by examining the transaction that follows: Step 4. Purchase inventory and equipment, in the amounts of $60 and $50, respectively. Now, the balance sheet reads Cash Inventory Equipment Total assets

$ 20 60

Paid-in capital Retained earnings

$100 30

50 $130

Total owners’ equity

$130

What claim does the $30 in the Retained Earnings account represent? Is it a claim on cash? It cannot be because the company has $30 of retained earnings and only $20 in cash. The company

ACCOUNTING FOR DIVIDENDS AND RETAINED EARNINGS

63

reinvested part of the cash in inventory and equipment. This example helps to explain the nature of the Retained Earnings account. It is a residual claim, not a pot of gold. A residual claim means that if the company went out of business and sold its assets for cash, the owners would receive the amount left over after the company paid its liabilities. This amount might be either more or less than the current balance in the Cash account and more or less than the current balance in the Retained Earnings account. Two examples highlight the lack of a direct relationship between cash and retained earnings. At the beginning of 2012 Royal Dutch Shell had retained earnings more than ten times larger than its cash balance: Cash, $11,292 million, and Retained Earnings, $162,987 million. On the same date, Amgen, one of the largest biotech companies in the world, had positive cash and negative retained earnings: Cash, $6,946 million, and Retained Earnings, $(8,919) million.

Statement of Stockholders’ Equity Because owners are interested in understanding the causes of changes in stockholders’ equity of a company, accountants have created a financial statement to do just that. The statement of stockholders’ equity (or statement of shareholders’ equity) shows all changes during the year in each stockholders’ equity account. It starts with the beginning balance in each account, followed by a list of all changes that occurred during the period, followed by the ending balance. Changes in stockholders’ equity arise from three main sources: 1. Net income or net loss. A period’s net income (net loss) increases (decreases) the balance in the retained earnings portion of stockholders’ equity. 2. Transactions with shareholders. For many companies, the most common transaction with shareholders is the declaration of dividends, which reduces retained earnings. Other transactions include issuing or repurchasing shares, which we discuss in Chapter 10. 3. Other comprehensive income (OCI). These are specific changes in stockholders’ equity that do not result from net income or transactions with shareholders. Items classified as other comprehensive income increase or decrease stockholders’ equity but are not recorded as part of paid-in capital or retained earnings. Rather, companies accumulate these items in a stockholders’ equity account entitled Accumulated Other Comprehensive Income (AOCI). Most items of other comprehensive income, except for one item discussed in Chapter 11, are beyond the scope of this text. Exhibit 2-8 shows Biwheels’ statement of stockholders’ equity for February. So far we have introduced only two stockholders’ equity accounts for Biwheels, Paid-in Capital (with possible sub-accounts for par value and additional paid-in capital) and Retained Earnings. We will focus here on Retained Earnings because it is the only Biwheels stockholders’ equity account that had changes in February. Most companies, like Biwheels, will have only two items that affect retained earnings: net income (or loss) and dividends. Other transactions, most having to do with repurchases of a company’s own common stock, can affect retained earnings. However, these transactions are less frequent, so we ignore them at this point. If Biwheels had a net loss (negative net income) we would subtract the amount from the beginning balance of retained earnings. If accumulated net losses plus dividends exceed accumulated net income, retained earnings would be negative. Many companies with negative retained earnings use the more descriptive term accumulated deficit.

  Beginning balance, January 31, 20X2

Paid-in Capital

Retained Earnings

$400,000

$57,900

Net income for February

63,900 (50,000)

Dividends declared Ending balance, February 28, 20X2

$400,000

$71,800

statement of stockholders’ equity (statement of shareholders’ equity) A statement that shows all changes during the year in each stockholders’ equity account.

other comprehensive income (OCI) Changes in stockholders’ equity that do not result from net income (net loss) or transactions with shareholders.

accumulated other comprehensive income (AOCI) Stockholders’ equity account that contains a cumulative total of all items classified as other comprehensive income.

accumulated deficit A more descriptive term for retained earnings when the accumulated net losses plus dividends exceed accumulated net income.

EXHIBIT 2-8 Biwheels Company Statement of Stockholders’ Equity, for the Month Ended February 28, 20X2

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Note how the income statement (Exhibit 2-7) and the changes in retained earnings (see Exhibit 2-8) are anchored to the balance sheet equation, where the bracketed items refer to retained earnings: Assets = Liabilities + Paid-in capital + Retained earnings [Beginning balance [$57,900

+ Revenues - Expenses - Dividends] + $176,000 - $112,100 - $50,000]

Ending retained earnings balance = $71,800

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S A company’s income statement reveals revenues of $50,000 and expenses of $40,000. Its balance sheet shows that retained earnings grew from $15,000 at the beginning of the year to $17,000 at the end of the year. What can you conclude about dividends declared?

Answer Because net income = (revenues − expenses), net income is ($50,000 − $40,000) = $10,000. Further, ending retained earnings = (beginning retained earnings + net income − dividends). This means that $17,000 = ($15,000 + $10,000 − dividends). Retained earnings would have been ($15,000 + $10,000) = $25,000 if the company had declared no dividends, but it was only $17,000. Therefore, the company must have declared ($25,000 − $17,000) = $8,000 in dividends.

Summary Problem for Your Review PROBLEM The following interpretations and remarks are common misinterpretations of financial statements. Explain fully the fallacy in each: 1. “Sales show the cash coming in from customers, and the various expenses show the cash going out for goods and services. The difference is net income.” 2. Consider the following March 31, 2011, accounts of Sony Corporation, the large Japanese electronics company. Sony Corporation Stockholders’ Equity (Yen in billions) March 31

2010

2011

Stockholders’ equity Common stock Authorized shares: 2010 and 2011, 3,600 million Issued and outstanding shares: 2010, 1,003.5 million; 2011, 1,003.6 million Additional paid-in capital Retained earnings Other Total stockholders’ equity

¥ 626 1,158 1,851 (349) ¥3,286

¥ 626 1,160 1,566 (415) ¥2,937

A Sony employee commented, “Why can’t Sony pay higher wages and dividends, too? It can use its more than ¥1.56 trillion (more than US$19.5 billion) of retained earnings to do so.” 3. “The total Sony stockholders’ equity measures the amount that the shareholders would get today if the corporation ceased business, sold its assets, and paid off its liabilities.”

FOUR POPULAR FINANCIAL RATIOS

65

SOLUTION 1. Cash receipts and disbursements are not the basis for the accrual accounting recognition of revenues and expenses. Sales could easily be credit sales for which the company has not yet received cash, and expenses could be those that the company has incurred but not yet paid out (or paid out in a previous accounting period). Depreciation is an example where the expense recognition does not coincide with the payment of cash. Depreciation recorded in today’s income statement may result from the use of equipment that the company acquired for cash years ago. Therefore, under accrual accounting, sales and expenses are not equivalent to cash inflows and outflows. To determine net income under accrual accounting, we subtract expenses from revenues (expenses are linked to revenues via matching). This can be quite different from cash inflows minus cash outflows. 2. As the chapter indicated, retained earnings is not cash. It is a stockholders’ equity account that represents the accumulated increase in ownership claims due to profitable operations. This claim may be lowered by declaring cash dividends, but a growing company will need to reinvest cash in receivables, inventories, plant, equipment, and other assets necessary for expansion. Paying higher wages may make it impossible to compete effectively and stay in business. Paying higher dividends may make it impossible to grow. The level of retained earnings does not lead to a specific wage or dividend policy for the firm. 3. Stockholders’ equity is the excess of assets over liabilities. If a company carried its assets in the accounting records at their current market values and listed the liabilities at their current market values, the remark would be true. However, many of the numbers on the balance sheet are historical numbers, not current numbers. Intervening changes in markets and general price levels in inflationary times may mean that some assets are woefully understated. Investors make a critical error if they think that balance sheets indicate current values for all assets.

Four Popular Financial Ratios Now that you know the basics of balance sheets and income statements, you are ready to learn how investors use some of the information in these statements. Numbers are hard to understand out of context. Is $10 a lot to pay for a share of stock? Is $1 a good dividend? To show you how investors think about such questions, let’s look at a few financial ratios that compare financial statement numbers in ways that help us to understand the economic meaning of the numbers. We compute a financial ratio by dividing one number by another. For a set of complex financial statements, we can compute literally hundreds of ratios. Every analyst has a set of favorite ratios, but earnings per share (EPS) of common stock is among the most frequently used. EPS is net income divided by the weighted-average number of common shares outstanding during the period over which the net income is measured. It is the only financial ratio required in the body of the financial statements. Publicly held companies must report it on the face of their income statements under both IFRS and U.S. GAAP. Let us now examine EPS and three other popular ratios.

Earnings Per Share EPS tells investors how much of a period’s net income “belongs to” each share of common stock. When a company’s owners’ equity is relatively simple, computing EPS is straightforward, and the company reports only one number, basic EPS. General Mills reported basic EPS of $1.96, $2.32, and $2.80 in 2009, 2010, and 2011, respectively. The calculation for 2011 follows: EPS = 2011 EPS =

Net income Average number of common shares outstanding $1,798,300,000 = $2.80 642,700,000

OBJECTIVE 6 Compute and explain earnings per share, price-earnings ratio, dividend-yield ratio, and dividend-payout ratio.

earnings per share (EPS) Basic EPS is net income divided by the weighted-average number of common shares outstanding during the period over which the net income is measured.

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Most income statements, including that of General Mills, show two EPS numbers, basic and diluted. At this point we focus only on basic EPS. Diluted EPS shows the potential decline in EPS if persons who have a right to acquire common shares at less than full market value, mainly due to stock option grants and debt that is convertible into common stock, exercise that right. We discuss diluted EPS in Chapter 10. Investors interested in purchasing General Mills stock might be interested in the cause of the company’s 20.7% increase in EPS from 2010 to 2011. From a review of the company’s 10-K report, we can see that the increase in EPS was caused by an increase in net earnings, from $1,530.5 million in 2010 to $1,798.3 million in 2011, coupled with a decrease in the average number of common shares outstanding. The increase in net income, as noted previously, is the result of a modest increase in sales, cost-saving initiatives and efficiencies, and a reduction in taxes. The average number of common shares outstanding decreased because the company repurchased some of its own shares in the stock market. Investors can weigh the reported EPS numbers and management’s explanation when forming their predictions of future EPS and deciding whether to invest in the stock.

Price-Earnings Ratio price-earnings (P-E) ratio Market price per share of common stock divided by earnings per share of common stock.

Another popular ratio is the price-earnings (P-E) ratio: [email protected] ratio =

Market price per share of common stock Earnings per share of common stock

The numerator is typically the most recent market price for a share of the company’s stock. The denominator is the EPS for the most recent 12 months. Thus, the P-E ratio varies throughout a given year, depending on the fluctuations in the company’s stock price. For example, General Mills’ P-E ratios at the end of fiscal 2011, 2010, and 2009 (on May 29, 2011, May 30, 2010, and May 31, 2009) were as follows: 2011 [email protected] = $39.29 , $2.80 = 14.0 2010 [email protected] = $36.65 , $2.32 = 15.8 2009 [email protected] = $25.59 , $1.96 = 13.1 earnings multiple Another name for the P-E ratio.

Another name for the P-E ratio is the earnings multiple. It measures how much the investing public is willing to pay for a chance to share the company’s potential earnings. Note especially that the marketplace determines the P-E ratio. Why? Because the market establishes the price of a company’s shares. The P-E ratio may differ considerably for two companies within the same industry. It may also change for the same company through the years. General Mills’ P-E increased 20.6% between 2009 and 2010. The low P-E ratio in 2009 may be partially a result of the company’s low stock price during the overall market decline of 2008–2009. The 43.2% increase in the stock price from 2009 to 2010 may reflect both investors’ belief that General Mills’ EPS would continue to increase and the renewed market confidence that was present at that time. Notice that the stock price increase of 7.2% was modest from 2010 to 2011 when compared with the 20.7% increase in EPS. This resulted in an 11.4% decrease in the P-E ratio in 2011. In general, the P-E ratio indicates investors’ predictions about the company’s future net income. Investors apparently were less optimistic about the growth rate for General Mills’ earnings at the end of 2011 than they were a year earlier. This may, in part, be due to the fact that cost-savings rather than sales growth caused most of the increased earnings in 2011, and there is a limit to the amount of costs that can be saved. Consider Under Armour, a company that develops, markets and distributes performance apparel, footwear and accessories. You may be familiar with its products, which are sold worldwide to athletes of all levels. On December 31, 2011, Under Armour had a P-E of 38.19. Compare that with General Mills’, which has consistently had a P-E ratio in the mid-teens. These ratios tell us that investors expect Under Armour’s earnings to grow more rapidly than General Mills’ earnings. The Business First box on page 67 illustrates the P-E ratios of some of the largest companies in the world.

FOUR POPULAR FINANCIAL RATIOS

67

BUSINESS FIRST M A R K E T VA L U E , E A R N I N G S , A N D P - E R AT I O S Forbes ranks the largest global companies by a variety of criteria, including sales, profits, assets, and market value. The following table lists the 10 largest companies ranked on market value as measured by Forbes on March 11, 2011. Company ExxonMobil Apple PetroChina ICBC Petrobras-Petroleo BHP Billiton*** China Construction Bank General Electric Microsoft Royal Dutch Shell

Country

Market Value in Billions

U.S. U.S. China China Brazil Australia China U.S. U.S. Netherlands

$407.2 $324.3 $320.8 $239.5 $238.8 $231.5 $224.8 $216.2 $215.8 $212.9

EPS* $ 6.24 $15.41 $12.70 ¥ 0.48** $ 3.88 $ 4.29 ¥ 0.56** $ 1.06 $ 2.73 $ 3.28

Stock Price*

P-E Ratio

$ 82.12 $351.99 $139.41 ¥ 4.30** $ 39.43 $ 89.59 ¥ 7.05** $ 20.36 $ 25.68 $ 68.86

13.2 22.8 11.0 9.0 10.2 20.9 12.6 19.2 9.4 21.0

*Stock price is as of March 11, 2011, and EPS is for fiscal year-end closest to March 11, 2011. For most companies this was December 31, 2010. **¥ = Chinese Yuan. ***Combined market value of BHP Billiton Ltd and BHP Billiton PLC (a dual-listed company with headquarters in Australia and the U.K.); Stock price shown is for the Australian registered BHP Billiton Ltd, which is the majority partner.

First, consider what companies are among the 10 largest market-cap companies. You might expect that there would be little movement in this list. However, just 2 years ago, 6 of the top 10 were U.S. companies (ExxonMobil, Wal-Mart, Microsoft, Procter & Gamble, AT&T, and Johnson & Johnson). In the last 2 years, 4 U.S. companies (Wal-Mart, Procter & Gamble, AT&T, and Johnson & Johnson) fell off the list and two other U.S. companies (Apple and General Electric) were added. Other new additions in 2011 were Petrobras-Petroleo, BHP Billiton, and China Construction Bank. Looking back just a little further, 6 years ago, 8 of the top 10 were U.S. companies and no company from China was in the top 25. Note the concentration of firms on the list that are involved in energy production or mining. Five of the 10 companies are engaged in the energy business. ExxonMobil, Royal Dutch Shell, PetroChina, and Petrobras-Petroleo are all primarily involved in oil and

gas exploration, production, development, and distribution. However, the companies also engage in development of renewable energies. BHP Billiton is a global mining company that mines numerous products including copper, silver, lead, zinc, iron ore, and coal. The company is also involved in oil and gas exploration, production, development, and marketing. While the companies operate in similar industries, their P-E ratios vary. Royal Dutch Shell and BHP Billiton have almost identical P-E ratios, at 21.0 and 20.9, respectively. On the other hand, PetroChina and Petrobras-Petroleo have P-E ratios that are approximately half of Royal Dutch Shell’s, 11.0 and 10.2, respectively. This suggests that investors may expect variation in the rate of company growth, even within related industries. Sources: Forbes.com, “The World’s Biggest Public Companies,” April 20, 2011; http:// www.reuters.com/; Web sites for ExxonMobil, Apple, PetroChina, ICBC, PetrobrasPetroleo, BHP Billiton, China Construction Bank, General Electric, Microsoft, and Royal Dutch Shell.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S From Microsoft’s financial statements, you can determine that its basic EPS grew from $1.63 in 2009 to $2.73 in 2011, an increase of almost 67.5%. At the same time, its stock price increased from slightly less than $24 per share on June 30, 2009, to about $26 per share on June 30, 2011, an increase of only 8.3%. What happened to Microsoft’s P-E ratio between 2009 and 2011? What would its price have been in 2011 if it had maintained its 2009 P-E ratio?

Answer Microsoft’s P-E in 2009 was ($24 ÷ $1.63) = 14.7, and by 2011 it had fallen to ($26 ÷ $2.73) = 9.5. If the company had a P-E ratio of 14.7 in 2011, its price would have been (14.7 × $2.73) = $40.13, or more than 1.5 times higher than it was.

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

Dividend-Yield Ratio

dividend-yield ratio Common dividends per share divided by market price per share.

Individual investors are interested in the profitability of their personal investments in common stock. That profitability takes two forms: cash dividends and increases in the market price of the stock. Investors in common stock who seek regular cash returns on their investments pay particular attention to dividend ratios. One such ratio is the dividend-yield ratio, the common dividends per share divided by the current market price of the stock. General Mills’ recent dividend-yield ratios were as follows: 2011 [email protected] = $1.12 , $39.29 = 2.85% 2010 [email protected] = $ .96 , $36.65 = 2.62% 2009 [email protected] = $ .86 , $25.59 = 3.36% Investors who favor high current cash returns do not generally buy stock in growth companies. Growth companies have conservative dividend policies because they use most of their profit-generated resources to help finance expansion of their operations. General Mills’ dividend-yield is typical for a company with stable but not exceptional growth. According to General Mills’ Web site, it targets a dividend yield in the 2% to 3% range. The actual dividend yields for 2009 through 2011 are consistent with this target. The ratio decreased in 2010 because the company experienced a significant increase in stock price as the market recovered from the lingering economic downturn. The ratio increased modestly in 2011 as both dividends and stock price rose.

Dividend-Payout Ratio dividend-payout ratio Common dividends per share divided by earnings per share.

Analysts are also interested in what proportion of net income a company elects to pay in cash dividends to its shareholders. The formula for computing the dividend-payout ratio is given here, followed by General Mills’ recent ratios: Common dividends per share Earnings per share 2011 [email protected] = $1.12 , $2.80 = 40.0% 2010 [email protected] = $ .96 , $2.32 = 41.4% 2009 [email protected] = $ .86 , $1.96 = 43.9% [email protected] ratio =

General Mills reports a relatively stable dividend-payout ratio. The company steadily increased both its dividends and EPS from 2009 to 2011. The General Mills’ Web site notes that the company has paid regular dividends without interruption for 113 years and has experienced dividend growth at a 12 percent compound rate over the 2007 to 2011 time period. A stated goal of the company is to continue to increase dividends over time as earnings grow. Many companies elect to continue a stable or increasing pattern of dividends, even if this creates variations in its dividend-payout ratio.

Stock Price and Ratio Information in the Press The business section of many daily newspapers in the United States reports market prices for stocks listed on major stock exchanges such as the NYSE, American Stock Exchange, or NASDAQ. The Wall Street Journal publishes end-of-day price quotes for the 1,000 largest stocks every day and shows more details on Saturdays. Consider the following stock quotations for General Mills in the Saturday, October 1, 2011, issue of the Wall Street Journal: 52 Weeks YTD % CHG

High

Low

Stock

SYM

YLD %

P-E

LAST

NET CHG

8.15

40

34.54

GenMills

GIS

3.2

15

38.49

−0.42

These data represent trading on Friday, September 30. Notice that the fourth and fifth columns identify General Mills and show that its ticker symbol is GIS. All listed stocks have short ticker symbols that identify them. Stock exchanges created these symbols years ago to facilitate communication via ticker tape, but they remain effective for computer communication today.

The Portfolio The Portfolio is your key to understanding a company’s financial position and prospects using the three major financial statements—the balance sheet, the statement of earnings, and the statement of cash flows. It shows some of the most important financial ratios used in analyzing Starbucks’ financial statements—and the statements of other companies. You can use this tool in financial statement analysis throughout the course. As you review this portfolio, it is useful to be aware that, in addition to Starbucks’ shareholders, there are other shareholders—referred to as a “noncontrolling interest”— who own a share of Starbucks’ assets and income through their part-ownership of Starbucks’ subsidiaries. Noncontrolling interests are discussed in Chapter 11. Ratios that relate to Starbucks’ shareholders, such as Earnings per Common Share and Return on Common Stockholders’ Equity, use only the amounts attributable to them. Ratios that relate to overall company performance use net income and total equity, which include both Starbucks’ shareholders’ interests and noncontrolling interests.

P1

P2

$3,794.9 = 1.83 $2,075.8 Starbucks has $1.83 in current assets for each $1 in current liabilities. See Chapter 4. Current Ratio =

Starbucks Corporation Consolidated Balance Sheets In millions, except per share data

Oct. 2, 2011

Oct. 3, 2010

Current assets: Cash and cash equivalents Short-term investments—available-for-sale securities Short-term investments—trading securities Accounts receivable, net Inventories Prepaid expenses and other current assets Deferred income taxes, net Total current assets

$ 1,148.1 855.0 47.6 386.5 965.8 161.5 230.4 3,794.9

$1,164.0 236.5 49.2 302.7 543.3 156.5 304.2 2,756.4

Long-term investments—available-for-sale securities Equity and cost investments Property, plant, and equipment, net Other assets Other intangible assets Goodwill TOTAL ASSETS

107.0 372.3 2,355.0 297.7 111.9 321.6 $7,360.4

191.8 341.5 2,416.5 346.5 70.8 262.4 $6,385.9

ASSETS

LIABILITIES AND EQUITY $2,973.1 = .40 $7,360.4 Starbucks uses $.40 of debt financing for every $1 of total assets. See Chapter 9. [email protected]@[email protected] Ratio =

Current liabilities: Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes Insurance reserves Other accrued expenses Deferred revenue Total current liabilities

$ 540.0 364.4 148.3 109.2 145.6 319.0 449.3 2,075.8

$ 282.6 400.0 173.2 100.2 146.2 262.8 414.1 1,779.1

Long-term debt Other long-term liabilities Total liabilities

549.5 347.8 2,973.1

549.4 375.1 2,703.6

0.7 1.1 39.4 4,297.4 46.3 4,384.9 2.4 4,387.3 $ 7,360.4

0.7 106.2 39.4 3,471.2 57.2 3,674.7 7.6 3,682.3 $6,385.9

Shareholders’ equity: Common stock ($.001 par value)– authorized, 1,200.0 shares; issued and outstanding, 744.8 and 742.6 shares, respectively Additional paid-in capital Other additional paid-in capital Retained earnings Accumulated other comprehensive income Total shareholders’ equity Noncontrolling interests Total equity TOTAL LIABILITIES and EQUITY ($4,384.9 - 0) = $5.89 744.8 (The numerator is total shareholders’ equity minus book value of preferred stock.) The shareholders’ equity associated with each share of Starbucks’ common stock is $5.89. See Chapter 10.

Book Value per Share of Common Stock =

$37.29 = 6.33 $5.89 The price of one share of Starbucks on Sunday, October 2, 2011, was $37.29, the closing price on Friday, September 30. The $5.89 amount is the book value per common share. Starbucks’ market value is 6.33 times its book value. See Chapter 10. [email protected]@Book =

($11,700.4 - $4,949.3) = 57.7% $11,700.4 Starbucks’ gross margin above the cost of items sold (including occupancy costs) is $.577 out of every $1 of sales. See Chapter 4. Gross Profit Percentage =

Starbucks Corporation Consolidated Statement of Earnings In millions, except per share data

Fiscal year ended

Oct. 2, 2011

Total net revenues

$11,700.4

Cost of sales including occupancy costs Store operating expenses Other operating expenses Depreciation and amortization expenses General and administrative expenses Total operating expenses Gain on sale of properties Income from equity investees Operating income Interest income and other, net Interest expense Earnings before income taxes Income taxes Net earnings including noncontrolling interests Net earnings attributable to noncontrolling interests Net earnings attributable to Starbucks

4,949.3 3,665.1 402.0 523.3 636.1 10,175.8 30.2 173.7 1,728.5 115.9 (33.3) 1,811.1 563.1 1,248.0 2.3 $ 1,245.7

Earnings per share—basic Earnings per share—diluted Weighted average shares outstanding: Basic Diluted

$ $

748.3 769.7

$1,248.0 = 10.7% $11,700.4 For every $1 of sales Starbucks earns net income of $.107. See Chapter 4. Return on Sales =

1.66 1.62

$1,245.7 = $1.66 748.3 This tells shareholders how much of Starbucks’ net earnings applies to each share of common stock they own. See Chapter 2. Earnings Per Common Share =

$37.29 = 22.5 $1.66 The price of one share of Starbucks’ stock on October 2, 2011, was $37.29. This ratio reveals how much value the market places on each dollar of Starbucks’ current earnings. See Chapter 2. [email protected] Ratio =

P3

P4

Inventory Turnover =

$4,949.3 = 6.6 [1>2 * ($965.8 + $543.3)]

Accounts Receivable Turnover =

Starbucks has cost of sales that is 6.6 times its average inventory level. This means it holds its inventory an average of (365 ÷ 6.6) = 55.3 days. See Chapter 7.

$11,700.4 = 34.0 [1>2 * ($386.5 + $302.7)]

Assuming that all Starbucks’ sales are on credit, it has credit sales that are 34.0 times its average receivables. This means that it collects its receivables in an average of (365 ÷ 34.0) = 10.7 days. See Chapter 6.

Starbucks Corporation Consolidated Balance Sheets In millions, except per share data

Oct. 2, 2011

Oct. 3, 2010

$ 1,148.1 855.0 47.6 386.5 965.8

$ 1,164.0 236.5 49.2 302.7 543.3

161.5 230.4 3,794.9

156.5 304.2 2,756.4

107.0 372.3 2,355.0 297.7 111.9 321.6 $ 7,360.4

191.8 341.5 2,416.5 346.5 70.8 262.4 $ 6,385.9

ASSETS

Current assets: Cash and cash equivalents Short-term investments—available-for-sale securities Short-term investments—trading securities Accounts receivable, net Inventories Prepaid expenses and other current assets Deferred income taxes, net Total current assets Long-term investments—available-for-sale securities Equity and cost investments Property, plant, and equipment, net Other assets Other intangible assets Goodwill TOTAL ASSETS LIABILITIES AND EQUITY

Return on Assets =

$1,248.0 = 18.2% [1>2 * ($7,360.4 + $6,385.9)]

For each $1 of assets that Starbucks owns, it generates $.182 of net earnings. See Chapter 4. Current liabilities:

Accounts payable Accrued compensation and related costs Accrued occupancy costs Accrued taxes Insurance reserves Other accrued expenses Deferred revenue Total current liabilities Long-term debt Other long-term liabilities Total liabilities Shareholders’ equity: Common stock ($.001 par value) — authorized, 1,200.0 shares; issued and outstanding, 744.8 and 742.6 shares, respectively Additional paid-in capital Other additional paid-in capital Retained earnings Accumulated other comprehensive income Total shareholders’ equity Noncontrolling interests Total equity TOTAL LIABILITIES and EQUITY

$ 540.0 364.4 148.3 109.2 145.6 319.0 449.3 2,075.8 549.5 347.8 2,973.1

0.7 1.1 39.4 4,297.4 46.3 4,384.9 2.4 4,387.3 $7,360.4

Return on Common Stockholders’ Equity =

$

282.6 400.0 173.2 100.2 146.2 262.8 414.1 1,779.1 549.4 375.1 2,703.6

0.7 106.2 39.4 3,471.2 57.2 3,674.7 7.6 3,682.3 $ 6,385.9 $1,245.7 = 30.9% [1>2 * ($4,384.9 + $3,674.7)]

For each $1 invested or reinvested by common stockholders, Starbucks generates $.309 of net earnings. See Chapter 4.

P5

Starbucks Corporation Consolidated Statement of Earnings In millions, except per share data

Fiscal year ended Net revenues Cost of sales including occupancy costs Store operating expenses Other operating expenses Depreciation and amortization expenses General and administrative expenses Total operating expenses Gain on sale of properties Income from equity investees Operating income Interest income and other, net Interest expense Earnings before income taxes Income taxes Net earnings Net earnings attributable to noncontrolling interests Net earnings attributable to Starbucks Earnings per share—basic Earnings per share—diluted Weighted average shares outstanding: Basic Diluted

Oct. 2, 2011 $ 11,700.4 4,949.3 3,665.1 402.0 523.3 636.1 10,175.8 30.2 173.7 1,728.5 115.9 (33.3) 1,811.1 563.1 $ 1,248.0 2.3 $ 1,245.7 $ $

1.66 1.62 748.3 769.7

P6

Starbucks Corporation Consolidated Statement of Cash Flows In millions

Fiscal year ended

Oct. 2, 2011

OPERATING ACTIVITIES:

Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization Gain on sale of properties Provision for impairments and asset disposals Deferred income taxes, net Equity in income of investees Distributions of income from equity investees Gain resulting from acquisition of joint ventures Stock-based compensation Excess tax benefit from exercise of stock options Other Cash provided/(used) by changes in operating assets and liabilities: Accounts receivable Inventories Accounts payable Accrued taxes Deferred revenue Other operating assets Other operating liabilities Net cash provided by operating activities

$1,248.0 550.0 (30.2) 36.2 106.2 (118.5) 85.6 (55.2) 145.2 (103.9) (2.9) (88.7) (422.3) 227.5 104.0 35.8 (22.5) (81.9) 1,612.4

INVESTING ACTIVITIES:

Purchase of available-for-sale securities Maturities and calls of available-for-sale securities Acquisitions, net of cash acquired Net (purchases)/sales of equity, other investments, and other assets Additions to property, plant, and equipment Proceeds from sale of property, plant, and equipment Net cash used by investing activities

(966.0) 430.0 (55.8) (13.2) (531.9) 117.4 (1,019.5)

FINANCING ACTIVITIES:

Proceeds from short-term borrowings Purchase of noncontrolling interest Proceeds from issuance of common stock Excess tax benefit from exercise of stock options Principal payments on long-term debt Cash dividends paid Repurchase of common stock Other Net cash used by financing activities Effect of exchange rate changes on cash and cash equivalents Net decrease in cash and cash equivalents

30.8 (27.5) 235.4 103.9 (4.3) (389.5) (555.9) (0.9) (608.0) (0.8) (15.9)

CASH AND CASH EQUIVALENTS:

Beginning of period End of period

1,164.0 $1,148.1 Free Cash Flow = ($1,612.4 -$531.9) = $1,080.5 Starbucks generated $1,080.5 more cash from its operations than it needed to invest in maintaining and expanding its property, plant, and equipment. See Chapter 5.

CONCEPTUAL FRAMEWORK

69

Reading from left to right, General Mills’ stock price increased by 8.15% between January 1 and September 30, 2011. The highest price at which General Mills’ common stock sold in the preceding 52 weeks was $40.00 per share; the lowest price was $34.54. The current annual dividend yield is 3.2% based on the day’s closing price of the stock. The P-E ratio is 15, also based on the closing price. The closing price—that is, the price of the last trade for the day—was $38.49, which was $.42 lower than the last trade on Thursday, September 29. That means that the closing price on September 29 was ($38.49 + $.42) = $38.91, and shareholders lost $.42 on each share they held on September 30. Keep in mind that transactions in publicly traded shares are between individual investors in the stock, not between the corporation and the individuals. Thus, a “typical trade” results in the selling of, for example, 100 shares of General Mills stock held by Ms. Johnson in Minneapolis to Mr. Ruiz in Atlanta for $3,849 in cash. These parties would ordinarily transact the trade through their respective stockbrokers. The trade would not directly affect General Mills, except that it would change its records of shareholders to show that Ruiz, not Johnson, holds the 100 shares.

Summary Problem for Your Review PROBLEM On January 31, 2011, the first trading day after the Sunday, January 30 year end, The Home Depot stock sold at about $36.80 per share. The company had net income of $3,338 million for the fiscal year ending January 30, 2011, had an average of 1,648 million common shares outstanding during the year, and paid common dividends of $.945 per share. Calculate and interpret the following: Earnings per share Price-earnings ratio

Dividend-yield ratio Dividend-payout ratio

SOLUTION (in millions of dollars) Earnings per share [email protected] ratio [email protected] ratio [email protected] ratio

= = = =

$3,338 , 1,648 = $2.03 $36.80 , $2.03 = 18.1 $.945 , $36.80 = 2.6% $.945 , $2.03 = 46.6%

The Home Depot had net income of $2.03 for each share of its common stock. Its market price was 18.1 times its earnings. This is higher than the S&P 500 average P-E ratio as of January 1, 2011, and shows that investors expect continuing growth in The Home Depot’s earnings. Home Depot paid out 46.6% of its income in dividends, which results in a 2.6% return for investors as of January 30, 2011. The dividend-yield ratio for the year ended January 30, 2011, is consistent with the historical average for Home Depot over the last 5 years. The dividend-payout ratio has been volatile over the last 5 years, ranging from a high of 56.9% in the fiscal year ended January 31, 2010, to a low of 24.1% for fiscal year ended January 28, 2007. Home Depot is apparently trying to maintain a record of steadily increasing dividend amounts despite fluctuating earnings.

Conceptual Framework As we learned in Chapter 1, financial statements are based on a set of generally accepted accounting principles (GAAP) as determined by the Financial Accounting Standards Board (FASB) in the United States and the International Accounting Standards Board (IASB) in most of the rest of the world. How do these boards decide what is acceptable and what is unacceptable in financial reporting? Ideally, GAAP would be based on an agreed-upon objective of financial reporting, a set of overriding concepts, principles derived from the concepts, and rules for implementing the principles. Both the FASB and IASB have attempted to achieve this by developing conceptual frameworks. Although there are some differences in the FASB and IASB conceptual frameworks, the similarities are much greater than the differences. Further, the two standard setting bodies are working together on a common framework to serve as the basis for developing worldwide standards. We will focus primarily on the FASB framework, but the discussion would be similar for

OBJECTIVE 7 Explain how the conceptual framework guides the standard setting process and how accounting regulators trade off relevance and faithful representation in setting accounting standards.

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objective of financial reporting To provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions.

the IASB framework. Understanding the conceptual framework will help you understand why companies prepare financial statements the way they do. Why is a conceptual framework necessary? When the FASB or IASB sets standards for financial reporting, they must make many judgments. Consider the accounting for the expiration of prepaid expenses. In the case of prepaid rent, it is easy to identify when the prepaid asset provides a benefit to the company. Rent becomes an expense in the period in which a company uses the rented facilities or equipment. However, some of the most difficult issues in accounting center on when a prepaid asset expires and becomes an expense. For example, some accountants believe that companies should first record research costs as an asset on the balance sheet and then gradually expense these costs in some systematic manner over a period of years. After all, companies engage in research activities because they expect them to create future benefits. However, both the IASB and the FASB have ruled that such costs have vague future benefits that are difficult to measure reliably. Therefore, companies must treat research costs as expenses when incurred. They do not appear on the balance sheet as assets. In contrast, under IFRS (but not U.S. GAAP) development costs that meet very specific criteria are considered assets and appear on the balance sheet. Other difficult questions faced by the FASB and IASB include the following: Should companies record an expense when they issue stock options to executives? If so, how should the company measure the expense? How should companies measure and disclose the expense for retirement benefits? Should companies show assets and liabilities at historical cost or current market value? The list could go on and on. The existence of a conceptual framework helps standard setters when faced with such difficult questions. What factors do the FASB and IASB consider when setting standards? They start with the objective of financial reporting—to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. Financial information is most useful to decision makers when it possesses certain qualitative characteristics, subject to practical constraints. As depicted in Exhibit 2-9, the conceptual framework identifies characteristics of information that lead to improved decision making. We next discuss these characteristics.

EXHIBIT 2-9 Qualities That Increase the Value of Information Decision Usefulness

Faithful Representation

Relevance

Predictive Value

Comparability

Confirmatory Value

Verifiability

Complete

Timeliness

Neutral

Free from Material Error

Understandability

CONCEPTUAL FRAMEWORK

71

Characteristics of Decision-Useful Information Relevance and faithful representation are the two main qualities that make accounting information useful for decision making. Relevance refers to whether the information makes a difference to the decision maker. If information has no impact on a decision, it is not relevant to that decision. The two attributes that can make information relevant are predictive value and confirmatory value. Information has predictive value if users of financial statements can use the information to help them form their expectations about the future. Information has confirmatory value if it can confirm or contradict existing expectations. Information that confirms expectations means that they become more likely to occur. Information that contradicts expectations will likely lead decision makers to change those expectations. Users of financial statements want assurance that management has accurately and truthfully reported its financial results. Consequently, in addition to relevance, accountants want information to exhibit faithful representation—that is, information should truly capture the economic substance of the transactions, events, or circumstances it describes. Faithful representation requires information to be complete, neutral, and free from material errors. Information is complete if it contains all the information necessary to faithfully represent an economic phenomenon. It is neutral if it is free from bias—that is, the information is not slanted to influence behavior in a particular direction. Finally, information should be free from material errors. This does not mean the complete absence of errors. Much accounting information is based on estimates that are, by definition, imperfect. Being free from material errors simply means that estimates are based on appropriate inputs, which in turn are based on the best information available. Accounting is filled with trade-offs between relevance and faithful representation. Consider the $4.0 billion balance sheet value of Weyerhaeuser Company’s timberlands, which the company shows at historical cost. Some of the land was purchased more than 50 years ago. The balance sheet value faithfully represents the historical cost of the timberlands, but the cost of land 50 years ago is not very relevant to today’s decisions. In contrast, the current value of the land is more relevant, but estimates of this current value are subjective and would be more difficult to represent faithfully. Which quality is more important? That answer depends on the specific decision being made. However, the most desirable information has both qualities: It is relevant and faithfully represents the phenomenon of interest. The prevailing view in the United States is that many current market value estimates, especially for property, plant, and equipment, are not sufficiently reliable to be included in the accounting records, even though they may be more relevant. However, under IFRS, companies can use current market values for such assets. As you can see on the bottom of Exhibit 2-9, four characteristics can enhance both relevance and faithful representation. The first such characteristic is comparability—requiring all companies to use similar concepts and measurements and to use them consistently. It requires accounting systems to treat like phenomena the same and unlike phenomena differently. Comparability helps decision makers identify similarities in and differences between the phenomena being represented. Note that comparability requires consistency, using the same accounting policies and procedures from period to period. Information is more useful if decision makers can compare it with similar information about other companies or with similar information for other reporting periods. For example, financial results of two companies are hard to compare if the companies used different methods of accounting for the value of their inventory. Further, we cannot make useful comparisons over time if a company constantly changes its accounting methods. The second enhancing characteristic is verifiability, which means that information can be checked to ensure it is correct. That is, knowledgeable and independent observers would agree that the information presented has been appropriately measured. For example, the historical cost of an item is verifiable because we can check the records to verify that the amounts are correct. In contrast, some estimates and appraisals are not easily verifiable. Timeliness is obviously desirable. Information must reach decision makers while it can still influence their decisions. Information that is not available until after decision makers act is of little value. Finally, information should be understandable. Understandability requires accountants to present information clearly and concisely. It does not require oversimplification of the data. That might fail to reveal important information. Complex phenomena sometimes require complex reporting. However, it is important to avoid unnecessary complexity.

relevance The capability of information to make a difference to the decision maker.

predictive value A quality of information that allows it to help users form their expectations about the future.

confirmatory value A quality of information that allows it to confirm or contradict existing expectations.

faithful representation A quality of information that ensures that it captures the economic substance of the transactions, events, or circumstances it describes. It requires information to be complete, neutral, and free from material errors.

comparability A characteristic of information produced when all companies use similar concepts and measurements and use them consistently.

consistency Using the same accounting policies and procedures from period to period.

verifiability A characteristic of information that can be checked to ensure it is correct.

timeliness A characteristic of information that requires information to reach decision makers while it can still influence their decisions.

understandability A characteristic of information that requires information to be presented clearly and concisely.

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Constraints

cost-effectiveness constraint Requirement that standard setting bodies choose rules whose decisionmaking benefits exceed the costs of providing the information.

When setting standards that provide decision-useful information, there are practical constraints that must be considered. One is the cost-effectiveness constraint. Accounting should improve decision making. This is a benefit. However, accounting information is an economic good that is costly to produce and use. The cost-effectiveness constraint requires that standard setting bodies must choose rules whose decision-making benefits exceed the costs of providing the information. The FASB and IASB safeguard the cost effectiveness of their standards by (1) ensuring a standard does not “impose costs on the many for the benefit of a few,” and (2) seeking alternative ways of handling an issue that are “less costly and only slightly less efficient.” The cost of providing information to the investing public includes expenses incurred by both companies and investors. Companies incur expenses for data collecting and processing, auditing, and educating employees. In addition, disclosure of sensitive information can lead to lost competitive advantages or increased labor union pressures. Investors’ expenses include the costs of education, analysis, and interpretation. The benefits of accounting information are often harder to pinpoint than the costs. For example, countries with emerging market economies often need to create an infrastructure of financial markets and relevant information to guide their economic development. However, the specific benefits of any particular proposal are harder to articulate than the general benefits of an intelligent system of accounting rules and procedures. While it can be difficult to explicitly identify and measure costs and benefits, standard setters attempt to weigh the cost effectiveness of a standard before its issuance.

Other Basic Concepts And Conventions OBJECTIVE 8 Explain how the following concepts affect financial statements: entity, going concern, materiality, stable monetary unit, periodicity, and reliability.

In addition to items in the conceptual framework, there are some basic concepts and conventions that are implicit in all financial statements. Now it is time to make some of these underlying assumptions explicit. In this section, we discuss the entity, going concern, materiality, stable monetary unit, periodicity, and reliability concepts and conventions.

The Entity Concept The first basic concept or principle in accounting is the entity concept. As you learned in Chapter 1, an accounting entity is an organization or a section of an organization that stands apart from other organizations and individuals as a separate economic unit. Accounting draws sharp boundaries around each entity to avoid confusing its affairs with those of other entities. An example of an entity is Berkshire Hathaway Inc., an enormous entity that encompasses many smaller entities. Just a few of the companies that are part of the Berkshire Hathaway corporate entity are insurance companies such as GEICO, General Re, United States Liability Insurance Group, National Indemnity Company; food companies such as International Dairy Queen and See’s Candies; jewelry companies such as Ben Bridge Jeweler, Helzberg Diamonds, and Borsheims Fine Jewelry; and numerous companies in the furniture, clothing, and other industries. Managers want accounting reports that are confined to their particular entities. The entity concept helps the accountant relate events to a clearly defined area of accountability. For example, do not confuse business entities with personal entities. A purchase of groceries for merchandise inventory is an accounting transaction of a grocery store (the business entity), but the store owner’s purchase of a DVD player with a personal check is a transaction of the owner (the personal entity).

Going Concern Convention going concern (continuity) A convention that assumes that an entity will persist indefinitely.

The going concern (continuity) convention is the assumption that an entity will persist indefinitely. This notion implies that a company will use its existing resources, such as plant assets, to fulfill its general business needs rather than sell them in tomorrow’s real estate or equipment markets. For a going concern, it is reasonable to use historical cost to record long-lived assets. The opposite view of this going concern convention is an immediate liquidation assumption, whereby a company values all items on its balance sheet at the amounts appropriate if the entity were to be liquidated in piecemeal fashion within a few days or months. Companies use this liquidation approach to valuation only when the probability is high that the company will be liquidated.

OTHER BASIC CONCEPTS AND CONVENTIONS

73

Materiality Convention How does an accountant know what to include on the financial statements? There are a lot of rules and regulations about what must appear in those statements. However, some items are insignificant enough that they need not be reported. The materiality convention asserts that an item should be included in a financial statement if its omission or misstatement would tend to mislead the reader of the financial statements under consideration. Most large items, such as buildings and machinery, are clearly material. Smaller items, though, may not be so clear-cut. Many acquisitions that a company theoretically should record as assets are immediately expensed because of their low dollar value. For example, coat hangers may last indefinitely but never appear in the balance sheet as assets. Many corporations require the immediate expensing of all outlays under a specified minimum, such as $1,000, regardless of the useful life of the asset acquired. The resulting $1,000 understatement of assets and stockholders’ equity is considered too insignificant to be of concern. In fact, the FASB regularly includes the following statement in its standards: “The provisions of this statement need not be applied to immaterial items.” When is an item material? There will probably never be a universal, clear-cut answer. What is trivial to General Electric may be material to a local clothing boutique. A working rule is that an item is material if its proper accounting is likely to affect the decision of an informed user of financial statements. In sum, materiality is an important convention, but it is difficult to use anything other than prudent judgment to tell whether an item is material.

materiality A convention that asserts that an item should be included in a financial statement if its omission or misstatement would tend to mislead the reader of the financial statements under consideration.

Stable Monetary Unit The monetary unit (called the dollar in the United States, the yen in Japan, the euro in the European Union, and various names elsewhere) is the principal means for measuring financial statement elements. It is the common denominator for quantifying the effects of a wide variety of transactions. Accountants record, classify, summarize, and report in terms of the monetary unit. The ability to use historical-cost accounting depends on a stable monetary unit. A stable monetary unit is simply one that is not expected to change in value significantly over time—that is, a 2013 dollar has about the same value as a 2000 dollar. Although this is not precisely correct, with low levels of inflation, the changes in the value of the monetary unit do not cause great problems.

The Periodicity Convention Earlier in the chapter we discussed the accounting time period. Recall that companies with publicly traded securities must file financial reports with the SEC on a quarterly and annual basis. However, companies frequently prepare monthly or even daily financial statements for internal use. For information to be useful, users must receive it on a timely basis. The periodicity convention requires that a company break up its economic activity into artificial time periods that will provide timely information to users.

The Reliability Concept Users of financial statements want assurance that management did not fabricate the numbers. Consequently, accountants regard reliability as an essential characteristic of measurement. Reliability is a quality of information that assures decision makers that the information captures the conditions or events it purports to represent. It is similar to representational faithfulness but also requires recording of data only when there is convincing evidence that can be verified by independent auditors. The accounting process focuses on reliable recording of events that affect an organization. Although many events may affect a company—including wars, elections, and general economic booms or depressions—accountants recognize only specified types of events as being reliably recorded as accounting transactions. Suppose a top executive of ExxonMobil is killed in an airplane crash. The accountant would not record this event. Now suppose that ExxonMobil discovers that an employee has embezzled $1,000 in cash. The accountant would record this event. The death of the executive may have greater economic or financial significance for ExxonMobil than does the embezzlement, but the monetary effect is hard to measure in any reliable way. The conceptual framework and these other concepts guide both standard setters and accountants. The standard setters use them to decide GAAP—principles that meet the concepts are preferred—and accountants use them to decide among alternative ways of recording and reporting transactions.

stable monetary unit A monetary unit that is not expected to change in value significantly over time. For example, the dollar in the United States, the yen in Japan, and the euro in the European Union.

periodicity convention Related to the information characteristic of timeliness, this convention requires that a company break up its economic activity into artificial time periods that will provide timely information to users.

reliability A quality of information that assures decision makers that the information captures the conditions or events it purports to represent.

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Highlights to Remember

1

Explain how accountants measure income. Accountants can measure income, the excess of revenues over expenses for a particular time period, on an accrual or cash basis. In accrual accounting, companies record revenue when they earn it and record expenses when they incur them. In cash accounting, companies record revenues and expenses only when cash changes hands. Accrual accounting is the standard basis for accounting today. Determine when a company should record revenue from a sale. The concept of revenue recognition means that companies record revenues in the earliest period in which they are both earned and realized or realizable. Earning is typically tied to delivery of the product or service and realization requires a high probability that the company will receive the promised resources (usually cash). Recording revenues increases stockholders’ equity. Use the concept of matching to record the expenses for a period. Under matching, companies assign expenses to the period in which they use the pertinent goods and services to create revenues, or when assets have no future benefit. Recording expenses decreases stockholders’ equity. Prepare an income statement and show how it is related to a balance sheet. An income statement shows an entity’s revenues and expenses for a particular period of time. The net income (loss) during the period increases (decreases) the amount of retained earnings on the balance sheet. Account for cash dividends and prepare a statement of stockholders’ equity. Cash dividends are not expenses. They are distributions of cash to stockholders that reduce retained earnings. Corporations are not obligated to pay dividends, but once the board of directors declares dividends they become a legal liability until paid in cash. The balance in retained earnings increases by the amount of net income and decreases by the amount of cash dividends. A statement of stockholders’ equity shows how net income, transactions with shareholders, and other comprehensive income affect stockholders’ equity accounts. Compute and explain EPS, P-E ratio, dividend-yield ratio, and dividend-payout ratio. Ratios relate one element of a company’s economic activity to another. EPS expresses overall earnings on a scale that individual investors can link to their own ownership level. The P-E ratio relates accounting earnings per share to market prices. The dividend-yield ratio relates dividends paid per share to market prices, and the dividend-payout ratio relates those same dividends to the earnings per share during the period. Explain how the conceptual framework guides the standard setting process and how accounting regulators trade off relevance and faithful representation in setting accounting standards. The primary objective of financial reporting is to provide information that is useful to present and potential investors and creditors and others in making investment, credit, and similar resource allocation decisions. Relevance and faithful representation are the two main qualities that make information useful. Information is relevant if it has predictive and/or confirmatory value. Faithful representation is characterized by information that is (a) complete, (b) neutral, and (c) free from material error. Characteristics that enhance both relevance and faithful representation are (a) comparability, (b) verifiability, (c) timeliness, and (d) understandability. Explain how the following concepts affect financial statements: entity, going concern, materiality, stable monetary unit, periodicity, and reliability. Authorities achieve comparability of financial statements by adopting concepts and conventions that all companies must use. Such concepts and conventions include the following: (a) accounting statements apply to a specific entity, (b) companies are assumed to be ongoing (not about to be liquidated), (c) items that are not large enough to be material need not follow normal rules, (d) accountants use the monetary unit for measurement despite its changing purchasing power over time, (e) accountants divide the economic activities into artificial time periods for reporting purposes, and (f) all transactions must have reliable measures.

2 3 4 5 6 7

8

ASSIGNMENT MATERIAL

Accounting Vocabulary accounts receivable, p. 50 accrual basis, p. 52 accumulated deficit, p. 63 accumulated other comprehensive income (AOCI), p. 63 cash basis, p. 52 cash cycle, p. 47 cash dividends, p. 61 comparability, p. 71 confirmatory value, p. 71 consistency, p. 71 continuity, p. 72 cost of goods sold, p. 51 cost of revenue, p. 51 cost of sales, p. 51 cost-effectiveness constraint, p. 72 depreciation, p. 54 dividend-payout ratio, p. 68 dividend-yield ratio, p. 68 earnings, p. 48 earnings multiple, p. 66

earnings per share (EPS), p. 65 expenses, p. 48 faithful representation, p. 71 fiscal year, p. 47 going concern, p. 72 income, p. 48 income statement, p. 57 interim periods, p. 47 matching, p. 53 materiality, p. 73 net earnings, p. 57 net income, p. 57 net loss, p. 57 objective of financial reporting, p. 70 operating cycle, p. 47 other comprehensive income (OCI), p. 63 period costs, p. 53 periodicity convention, p. 73 predictive value, p. 71 price-earnings (P-E) ratio, p. 66

product costs, p. 53 profits, p. 48 receivables, p. 50 relevance, p. 71 reliability, p. 73 retained earnings, p. 48 retained income, p. 48 revenue, p. 48 revenue recognition, p. 52 sales, p. 48 sales revenue, p. 48 stable monetary unit, p. 73 statement of earnings, p. 57 statement of operations, p. 57 statement of shareholders’ equity, p. 63 statement of stockholders’ equity, p. 63 timeliness, p. 71 trade receivables, p. 50 understandability, p. 71 verifiability, p. 71

Assignment Material Questions 2-1 How long is a company’s operating cycle? 2-2 What is the difference between a fiscal year and a calendar year? Why do companies use a fiscal year that differs from a calendar year? 2-3 “Expenses are negative stockholders’ equity accounts.” Explain. 2-4 What is the major defect of the cash basis of accounting? 2-5 What are the two criteria for the recognition of revenue? 2-6 Describe two scenarios where revenue is not recognized at the point of sale, one where recognition is delayed because the revenue is not yet earned, and one because it is not yet realized. 2-7 Distinguish product costs from period costs. 2-8 “Expenses are assets that have been used.” Explain. 2-9 “Companies acquire goods and services, not expenses per se.” Explain. 2-10 “The income statement is like a moving picture; in contrast, a balance sheet is like a snapshot.” Explain.

2-11 Give two synonyms for income statement. Why is it important to learn synonyms that are used for various accounting terms? 2-12 Why might a manager put pressure on accountants to report higher revenues or lower expenses than accounting standards allow? 2-13 “Cash dividends are not expenses.” Explain. 2-14 “Retained earnings is not a pot of gold.” Explain. 2-15 What do users learn from the statement of stockholders’ equity? What three types of changes are shown on the statement? 2-16 “An accounting entity is always a separate legal organization.” Do you agree? Explain. 2-17 “Financial ratios are important tools for analyzing financial statements, but no ratios are shown on the statements.” Do you agree? Explain. 2-18 “Fast-growing companies have high P-E ratios.” Explain. 2-19 Give two ratios that provide information about a company’s dividends, and explain what each means.

75

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2-20 “Companies with a high dividend-payout ratio are good investments because stockholders get more of their share of earnings in cash.” Do you agree? Explain. 2-21 “Relevance and faithful representation are both desirable characteristics for accounting measurements, but often it is not possible to have both.” Do you agree? Explain. 2-22 What two characteristics of accounting measurements make them relevant? Explain each.

2-23 Accounting numbers should be complete, neutral, and free from material errors. What characteristic of information do these criteria support? 2-24 How do accountants judge whether an item is reliable enough for reporting in the financial statements? 2-25 The concepts of materiality and costeffectiveness can limit the amount of detailed information included in the financial statements. Explain how an accountant might use each to exclude an item from the statements.

Critical Thinking Questions  OBJECTIVES 1, 8

2-26 Quarterly Versus Annual Financial Statements In the United States, it is common to provide abbreviated financial data quarterly with full financial statements provided annually. In some countries companies provide only annual data. Discuss the trade-offs.

 OBJECT IVE 1

2-27 Accrual or Cash Basis Which would you rather have, a cash-basis income statement or an accrual-basis income statement? Why?

 OBJECT IVE 5  OBJECTIVE 6

2-28 Dividends and Stock Prices Suppose a company was going to pay out one-half of its total assets as a cash dividend. What would you expect to happen to the value of the company’s stock as a result of the dividend? 2-29 Interpretation of the P-E Ratio Would you rather own a company with a high P-E ratio or a low P-E ratio? Why?

Exercises  OBJECTIVE 4

2-30 Synonyms and Antonyms Consider the following terms: (1) sales, (2) net earnings, (3) accumulated deficit, (4) unexpired costs, (5) prepaid expenses, (6) accounts receivable, (7) statement of earnings, (8) used-up costs, (9) net profits, (10) net income, (11) revenues, (12) retained earnings, (13) expenses, (14) statement of financial condition, (15) statement of income, (16) statement of financial position, (17) operating statement, and (18) cost of goods sold. Group the items into two categories, those on the income statement and those on the balance sheet. Answer by indicating the numbered items that belong in each group. Specify items that are assets and items that are expenses.

 OBJECT IVE 2

2-31 Special Meanings of Terms A news story described the disappointing sales of a new model car, the Jupiter. An auto dealer said, “Even if the Jupiter is a little slow to move out of dealerships, it is more of a plus than a minus. . . . We’re now selling 14 more cars per month at $20,000 per car. That’s $280,000 more income.” Is the dealer confused about accounting terms? Explain.

 OBJECT IVE 1

2-32 Cash Versus Accrual Accounting Yankton Company had sales of $240,000 during 20X0, all on account. Accounts receivable for the year grew from $50,000 on January 1 to $110,000 on December 31. Expenses for the year were $170,000, all paid in cash. 1. Compute Yankton’s net income on the cash basis of accounting. 2. Compute Yankton’s net income on the accrual basis of accounting. 3. Which basis gives a better measure of Yankton’s performance for 20X0? Why?

ASSIGNMENT MATERIAL

2-33 Nature of Retained Earnings This is an exercise on the relationships between assets, liabilities, and ownership equities. The numbers are small, but the underlying concepts are large.

77

 OBJECTIVE 5

1. Assume an opening balance sheet of Cash

$1,000

Paid-in capital

$1,000

2. Purchase inventory for $600 cash. Prepare a balance sheet. A heading is unnecessary in this and subsequent requirements. 3. Sell the entire inventory for $850 cash. Prepare a balance sheet. What does retained earnings represent and how is it related to other balance sheet accounts? Explain in your own words. 4. Buy inventory for $300 cash and equipment for $800 cash. Prepare a balance sheet. What does retained earnings represent and how is it related to other balance sheet accounts? Explain in your own words. 5. Buy inventory for $500 on open account. Prepare a balance sheet. What do retained earnings and account payable represent and how are they related to other balance sheet accounts? Explain in your own words. 2-34 Asset Acquisition and Expiration The Greenley Company had the following transactions in July: a. b. c. d.

 OBJECTIVE 3

Paid $18,000 cash for rent for the next 6 months on July 1. Paid $2,000 cash for supplies on July 3. Paid $4,000 cash for an advertisement in the next day’s New York Times on July 10. Paid $8,000 cash for a training program for employees on July 17. The training was completed in July.

Show the effects on the balance sheet equation in two phases—at acquisition and on expiration at the end of the month of acquisition. Show all amounts in thousands. 2-35 Find Unknowns The following data pertain to Liverpool Auto, Ltd. Total assets at January 1, 20X1, were £110,000; at December 31, 20X1, they were £126,000. During 20X1, sales were £360,000, cash dividends declared were £5,000, and operating expenses (exclusive of cost of goods sold) were £210,000. Total liabilities at December 31, 20X1, were £55,000; at January 1, 20X1, they were £50,000. There was no additional investment by stockholders during 20X1. Compute the following:

 OBJECTIVES 4, 5

1. Stockholders’ equity, January 1, 20X1, and December 31, 20X1 2. Net income for 20X1—ignore taxes 3. Cost of goods sold for 20X1 2-36 Recording Transactions The Piedmont Company had the following transactions during June 20X1: a. b. c. d.

Collections of accounts receivable, $75,000. Payment of accounts payable, $45,000. Acquisition of inventory, $18,000, on open account. Sale of merchandise, $30,000 on open account and $23,000 for cash. The sold merchandise cost Piedmont Company $28,000. e. Depreciation on equipment of $1,000 in June. f. Declared and paid cash dividends of $15,000. Use the balance sheet equation format to enter these transactions into the books of Piedmont Company. Suppose that Piedmont has a cash balance of $15,000 at the beginning of June. What was the cash balance on June 30?

 OBJECTIVES 1, 3, 4

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

 OBJECT IVE 4

2-37 Income Statement A statement of an automobile dealer follows: Freeway Volvo, Inc. Statement of Profit and Loss December 31, 20X0 Revenues Sales Increase in market value of land and building

$1,050,000 200,000

Deduct expenses Advertising Sales commissions Utilities Wages Dividends Cost of cars purchased Net profit

100,000 50,000 20,000 170,000 100,000 700,000

$1,250,000

1,140,000 $ 110,000

List and describe any shortcomings of this statement.

 OBJECT IVES 4, 5

2-38 Income Statement and Retained Earnings FedEx Corporation provides customers and businesses worldwide with a broad portfolio of transportation, e-commerce, and business services. In the year ended May 31, 2011, FedEx had revenues of $39,304 million and total expenses of $37,852 million. FedEx Corporation’s retained earnings were $13,966 million at the beginning of the year and $15,266 million at the end of the year. 1. Compute FedEx Corporation’s net income (loss) for the year ended May 31, 2011. 2. Compute the amount of cash dividends declared by FedEx during the year ended May 31, 2011.

 OBJECT IVES 4, 5

2-39 Balance Sheet Equation (Alternates are 2-40 and 2-55.) Each of the following three columns is an independent case. For each case, compute the amounts ($ in thousands) for the items indicated by letters and show your supporting computations:

Revenues Expenses Dividends declared Additional investment by stockholders Net income Retained earnings Beginning of year End of year Paid-in capital Beginning of year End of year Total assets Beginning of year End of year Total liabilities Beginning of year End of year

1

Case 2

3

$165 130 — — E

$K 200 7 40 30

$290 250 Q 35 P

35 D

60 J

120 130

15 C

10 H

N 85

80 95

F 280

L M

90 G

105 95

A B

ASSIGNMENT MATERIAL

2-40 Balance Sheet Equation (Alternates are 2-39 and 2-55.) Xcel Energy, provider of gas and electricity to customers in 12 Midwestern and Rocky Mountain states, has the following actual data ($ in millions) for the year 2011: Total expenses Net income (loss) Dividends Assets, beginning of period Assets, end of period Liabilities, beginning of period Liabilities, end of period Shareholders’ equity, beginning of period Shareholders’ equity, end of period Retained earnings, beginning of period Retained earnings, end of period Total revenues

 OBJECTIVES 4, 5

$ B 841 510 27,388 D A 21,015 8,189 8,482 1,702 C 10,655

Find the unknowns ($ in millions), showing computations to support your answers. 2-41 Nonprofit Operating Statement Examine the accompanying statement of the Berlin University Faculty Club. Identify the Berlin University classifications and terms that would not be used by a profit-seeking hotel and restaurant in the United States. Suggest alternate terms. (€ is the European euro.) Berlin U Faculty Club Statement of Income and Expenses for Fiscal Year Food Service Sales Expenses Food Labor Operating costs Deficit Bar Sales Expenses Cost of liquor Labor Operating costs Surplus Hotel Sales Expenses Surplus Total surplus from operations General income (members’ dues, room fees, etc.) General administration and operating expenses Deficit before university subsidy University subsidy Net surplus after university subsidy

€548,130 €287,088 272,849 30,537

590,474 € (42,344) 90,549

29,302 5,591 6,125

41,018 49,531 33,771 23,803 9,968 17,155 95,546 (134,347) (21,646) 23,000 € 1,354

 OBJECTIVE 4

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 OBJECT IVE 6

2-42 Earnings and Dividend Ratios GlaxoSmithKline plc, the British pharmaceutical company, reported 2011 earnings of £5,458 million under IFRS. Cash dividends were £3,406 million. The company had an average of 5,099 million common shares outstanding. No other type of stock was outstanding. The market price of the stock at the end of the year was approximately £14.72 per share. Compute (1) EPS, (2) P-E ratio, (3) dividend-yield, and (4) dividend-payout ratio.

 OBJECT IVE 6

2-43 Earnings and Dividend Ratios Chevron Corporation is one of the largest oil companies in the world. The company’s revenue in 2011 was $573.706 billion. Net income was $26.895 billion. EPS was $13.54. The company’s common stock is the only type of shares outstanding. 1. Compute the average number of common shares outstanding during the year. 2. The dividend-payout ratio was 22.8%. What was the amount of dividends per share? 3. The market price of the stock at the end of the year was $106.40 per share. Compute (a) dividend-yield and (b) P-E ratio.

 OBJECTIVE 8

2-44 Assessing Materiality On December 31, 2011, ExxonMobil, the large petroleum company, reported total assets of $331,052 million and annual net income of $41,060 million. On the same date, Dayton Service Stations, Inc., operator of six gas stations in Dallas, reported total assets of $926,000 and annual net income of $224,000. 1. Suppose both companies made an investment of $250,000 in new equipment in January 2012. Would you expect the amount of detail about the investment that each company disclosed in its financial statements to differ? Why? 2. How would each company decide on its level of disclosure about the investment?

Problems  OBJECTIVES 1, 2, 3, 4

2-45 Fundamental Revenue and Expense R. J. Sen Corporation was formed on June 1, 20X0, when some stockholders invested $100,000 in cash in the company. During the first week of June, the company spent $85,000 cash for merchandise inventory (sportswear). During the remainder of the month, total sales reached $115,000, of which $70,000 was on open account. The cost of the inventory sold was $60,000. For simplicity, assume that no other transactions occurred except that on June 28, R. J. Sen Corporation acquired $34,000 additional inventory on open account. 1. By using the balance sheet equation approach demonstrated in Exhibit 2-3 (p. 49), analyze all transactions for June. Show all amounts in thousands. 2. Prepare a balance sheet for June 30, 20X0. 3. Prepare two statements for June, side by side. The first should use the accrual basis of accounting to compute net income, and the second, the cash basis to compute the difference between cash inflows and cash outflows. Which basis provides a more informative measure of economic performance? Why?

 OBJECT IVE 2

2-46 Revenue Recognition Footnote 1 to Microsoft’s 2011 annual report contained the following: Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable . . . . Revenue for retail packaged products, products licensed to original equipment manufacturers (OEMs) . . . generally is recognized as products are shipped or made available. . . . Certain multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period… . Revenue related to our Xbox 360 gaming and entertainment console, Kinect for Xbox 360, games published by us, and other hardware

ASSIGNMENT MATERIAL

components is generally recognized when ownership is transferred to the resellers. Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. 1. Explain how Microsoft’s revenue recognition policy meets the criteria of being earned and realized. 2. Discuss the accounting for multiyear licensing arrangements. 3. Discuss the accounting for revenue related to games published by third parties. 2-47 Analysis of Transactions, Preparation of Statements (Alternates are 2-48, 2-50, 2-52, and 2-54.) The Montero Company, a wholesale distributor of furnace and air conditioning equipment, began business on July 1, 20X2. The following summarized transactions occurred during July:

 OBJECTIVES 3, 4

a. Montero’s stockholders contributed $300,000 in cash in exchange for their common stock. b. On July 1, Montero signed a 1-year lease on a warehouse, paying $48,000 cash in advance for occupancy of 12 months. c. On July 1, Montero acquired warehouse equipment for $100,000. A cash down payment of $40,000 was made, and a note payable was signed for the balance. d. On July 1, Montero paid $24,000 cash for a 2-year insurance policy covering fire, casualty, and related risks. e. Montero acquired assorted merchandise for $35,000 cash. f. Montero acquired assorted merchandise for $190,000 on open account. g. Total sales were $205,000, of which $30,000 were for cash. h. Cost of inventory sold was $155,000. i. Rent expense was recognized for the month of July. j. Depreciation expense of $2,000 was recognized for the month. k. Insurance expense was recognized for the month. l. Collected $45,000 from credit customers. m. Disbursed $80,000 to trade creditors. For simplicity, ignore all other possible expenses. Required 1. By using the balance sheet equation format demonstrated in Exhibit 2-3 (p. 49), prepare an analysis of each transaction. Show all amounts in thousands. What do transactions (h)–(m) illustrate about the theory of assets and expenses? (Use a Prepaid Insurance account, which is not illustrated in Exhibit 2-3.) 2. Prepare an income statement for July on the accrual basis. Ignore income taxes. 3. Prepare a balance sheet for July 31, 20X2. 2-48 Analysis of Transactions, Preparation of Statements (Alternates are 2-47, 2-50, 2-52, and 2-54.) The Bekele Company was incorporated on April 1, 20X0. Bekele had 10 holders of common stock. Rosa Bekele, the president and chief executive officer, held 51% of the shares. The company rented space in chain discount stores and specialized in selling ladies’ accessories. Bekele’s first location was in a store that was part of The Old Market in Omaha. The following events occurred during April: a. b. c. d.

The company was incorporated. Common stockholders invested $200,000 cash. Purchased merchandise inventory for cash, $45,000. Purchased merchandise inventory on open account, $35,000. Merchandise carried in inventory at a cost of $37,000 was sold for cash for $25,000 and on open account for $75,000, for a grand total of $100,000. Bekele (not The Old Market) carries and collects these accounts receivable.

 OBJECTIVES 3, 4

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e. Collection of accounts receivable, $18,000. See transaction (d). f. Payments of accounts payable, $30,000. See transaction (c). g. Special display equipment and fixtures were acquired on April 1 for $36,000. Their expected useful life was 36 months. This equipment was removable. Bekele paid $12,000 as a down payment and signed a promissory note for $24,000. Also see transaction (k). h. On April 1, Bekele signed a rental agreement with The Old Market. The agreement called for a flat $2,000 per month, payable quarterly in advance. Therefore, Bekele paid $6,000 cash on April 1. i. The rental agreement also called for a payment of 10% of all sales. This payment was in addition to the flat $2,000 per month. In this way, The Old Market would share in any success of the venture and be compensated for general services such as cleaning and utilities. This payment was to be made in cash on the last day of each month as soon as the sales for the month had been tabulated. Therefore, Bekele made the payment on April 30. j. Employee wages and sales commissions were all paid for in cash. The amount was $34,000. k. Depreciation expense of $1,000 was recognized ($36,000,36 months). See transaction (g). l. The expiration of an appropriate amount of prepaid rental services was recognized. See transaction (h). Required 1. Prepare an analysis of Bekele Company’s transactions, employing the balance sheet equation approach demonstrated in Exhibit 2-3 (p. 49). Show all amounts in thousands. 2. Prepare a balance sheet as of April 30, 20X0, and an income statement for the month of April. Ignore income taxes. 3. Given these sparse facts, analyze Bekele’s performance for April and its financial position as of April 30, 20X0.

 OBJECT IVES 1, 2

2-49 Accrual Versus Cash-Based Revenues (Alternate is 2-51.) Refer to the preceding problem. Suppose Bekele measured performance on the cash basis instead of on the accrual basis. Compute the cash receipts, cash disbursements, and net cash inflows (outflows) for April. Which measure, accrual-based net income or net cash inflows (outflows), provides a better measure of accomplishment? Why?

 OBJECT IVES 3, 4

2-50 Analysis of Transactions, Preparation of Statements (Alternates are 2-47, 2-48, 2-52, and 2-54.) H.J. Heinz Company’s actual condensed balance sheet data for April 27, 2011, follow ($ in millions): Cash Receivables Inventories Other assets Property, plant, and equipment Total

$

724 1,265 1,452 6,285 2,505 $12,231

Accounts payable Other liabilities Shareholders’ equity Total

$ 1,500 7,549 3,182 $12,231

The following summarizes a few transactions during May 2011 ($ in millions): a. Ketchup carried in inventory at a cost of $4 was sold for cash of $3 and on open account of $8, for a grand total of $11. b. Acquired inventory on account, $6. c. Collected receivables, $5. d. On May 2, used $12 cash to prepay some rent and insurance for 12 months. Heinz classifies prepaid expenses as Other Assets. e. Payments on accounts payable (for inventories), $4. f. Paid selling and administrative expenses in cash, $1. g. Prepaid expenses of $1 for rent and insurance expired in May. h. Depreciation expense of $2 was recognized for May.

ASSIGNMENT MATERIAL

Required 1. Prepare an analysis of Heinz’s transactions, employing the balance sheet equation approach demonstrated in Exhibit 2-3 (p. 49). Show all amounts in millions. 2. Prepare a statement of earnings for the month ended May 31 and a balance sheet as of May 31. Ignore income taxes. 2-51 Accrual Versus Cash-Based Revenue (Alternate is 2-49.) Refer to the preceding problem. Suppose Heinz measured performance on the cash basis instead of the accrual basis. Compute the cash receipts, cash disbursements, and net cash inflows (outflows) during May. Which measure, net income or net cash inflows (outflows), provides a better measure of overall performance? Why?

 OBJECTIVES 1, 2

2-52 Analysis of Transactions, Preparation of Statements (Alternates are 2-47, 2-48, 2-50, and 2-54.) Nestlé S.A. is a Swiss company that calls itself the world’s leading nutrition, health, and wellness company. It produces many food products including Nestlé Milk Chocolate and Nescafé. Nestlé’s condensed balance sheet data for July 1, 2011, reported under IFRS, follow (in millions of Swiss francs, CHF):

 OBJECTIVES 3, 4

Cash Receivables Inventories

CHF

2,833 11,946 8,885

Property, plant, and equipment Other assets Total

20,114 56,912 CHF100,690

Accounts payable Other liabilities Owners’ equity

Total

CHF 11,137 37,081 52,472

CHF100,690

The following summarizes a few transactions during July 2011 (CHF in millions): a. Products carried in inventory at a cost of CHF500 were sold for cash of CHF350 and on open account of CHF400, for a grand total of CHF750. b. Collection of receivables, CHF620. c. Depreciation expense of CHF30 was recognized. d. Selling and administrative expenses of CHF240 were paid in cash. e. Prepaid expenses of CHF50 expired in July. These included fire insurance premiums paid in the previous year that applied to future months. The expiration increases selling and administrative expenses and reduces other assets. Required 1. Prepare an analysis of Nestlé’s transactions, employing the balance sheet equation approach demonstrated in Exhibit 2-3 (p. 49). Show all amounts in millions. 2. Prepare a statement of earnings before taxes. Also prepare a balance sheet as of July 31. 2-53 Prepare Financial Statements The Ludmilla Corporation does not use the services of a professional accountant. At the end of its second year of operations, 20X2, the company’s office manager prepared its financial statements. Listed next in random order are the items appearing in these statements: Accounts receivable Paid-in capital Trucks Cost of goods sold Salaries expense Unexpired insurance Rent expense Sales Advertising expense Cash

$ 32,400 100,000 33,700 157,000 86,000 1,800 19,500 285,000 9,300 14,800

Office supplies inventory Notes payable Merchandise inventory Accounts payable Notes receivable Utilities expense Net income Retained earnings January 1, 20X2 December 31, 20X2

$ 2,000 8,000 61,000 14,000 2,500 5,000 8,200 18,000 26,200

 OBJECTIVES 3, 4

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You are satisfied that the statements in which these items appear are correct, except for several matters that the office manager overlooked. The following information should have been entered on the books and reflected in the financial statements: a. The amount shown for rent expense includes $2,000 that is actually prepaid for the first month in 20X3. b. Of the amount shown for unexpired insurance, only $800 is prepaid for periods after 20X2. c. Depreciation of trucks for 20X2 is $5,000. d. $1,200 of the office supplies in the inventory shown earlier was actually issued and used during 20X2 operations. e. Cash dividends of $4,000 were declared in December 20X2 by the board of directors. The company will distribute these dividends in February 20X3. Prepare in good form the following corrected financial statements, ignoring income taxes: 1. Income statement for 20X2 2. Statement of changes in retained earnings for 20X2 3. Balance sheet at December 31, 20X2 It is not necessary to prepare a columnar analysis to show the transaction effects on each element of the accounting equation.

 OBJECT IVES 3, 4, 5

2-54 Transaction Analysis and Financial Statements, Including Dividends (Alternates are 2-47, 2-48, 2-50, and 2-52.) Consider the following balance sheet of a wholesaler of children’s toys: Gecko Toy Company Balance Sheet, December 31, 20X0 Assets

Liabilities and Stockholders’ Equity

Cash Accounts receivable Merchandise inventory Prepaid rent

$ 400,000 400,000 860,000 45,000

Liabilities Accounts payable Stockholders’ equity Paid-in capital Retained earnings

Equipment Total

100,000 $1,805,000

Total stockholders’ equity Total

$ 800,000 $360,000 645,000 1,005,000 $1,805,000

The following is a summary of transactions that occurred during 20X1: a. Acquisitions of inventory on open account, $1 million. b. Sales on open account, $1.5 million; and for cash, $200,000. Therefore, total sales were $1.7 million. c. Merchandise carried in inventory at a cost of $1.3 million was sold as described in b. d. The warehouse 12-month lease expired on October 1, 20X1. However, the company immediately renewed the lease at a rate of $84,000 for the next 12-month period. The entire rent was paid in cash in advance. e. Depreciation expense for 20X1 for the warehouse equipment was $20,000. f. Collections on accounts receivable, $1.25 million. g. Wages for 20X1 were paid in full in cash, $200,000. h. Miscellaneous expenses for 20X1 were paid in full in cash, $70,000. i. Payments on accounts payable, $900,000. j. Cash dividends for 20X1 were declared and paid in full in December, $100,000. Required 1. Prepare an analysis of transactions, employing the balance sheet equation approach demonstrated in Exhibit 2-3 (p. 49). Show the amounts in thousands of dollars. 2. Prepare an ending balance sheet, a statement of income, and the retained earnings column of the statement of stockholders’ equity for 20X1.

ASSIGNMENT MATERIAL

3. Reconsider transaction j. Suppose the dividends were declared on December 15, 20X1, payable on January 31, 20X2, to shareholders of record on January 20. Indicate which accounts and financial statements in requirement 2 would be changed and by how much. Be complete and specific. 2-55 Balance Sheet Equation (Alternates are 2-39 and 2-40.) Merck & Co., Inc., the giant pharmaceutical company, had the following actual data for fiscal year ended December 31, 2011 ($ in millions): Assets, beginning of period Assets, end of period Liabilities, beginning of period Liabilities, end of period Other shareholders’ equity, beginning of period Other shareholders’ equity, end of period Retained earnings, beginning of period Retained earnings, end of period Total revenues Cost of sales and all other expenses Net earnings Dividends and other decreases in retained earnings

 OBJECTIVES 4,5

$105,781 105,128 A D 19,269 17,953 37,536 C 48,047 41,775 B 4,818

Find the unknowns ($ in millions), showing computations to support your answers. 2-56 Two Sides of a Transaction For each of the following transactions, show the effects on the entities involved. As was illustrated in the chapter, use the Assets = Liabilities + Owners’ equity (A = L + OE) equation to demonstrate the effects. Using the accounts in the illustration below, show the dollar amounts and indicate whether the effects are increases or decreases. ILLUSTRATION The Nebraska State Hospital collects $1,000 from the Blue Cross Health Care Plan. A Entity Hospital Blue Cross

1. 2. 3. 4.

5. 6. 7. 8. 9. 10.

Cash +1,000 −1,000

+

Other Assets −1,000

= + Trucks = = =

L

+ OE

Liabilities

−1,000

Borrowing of $150,000 on a home mortgage from Fidelity Savings by David Stratton. Payment of $10,000 principal on the preceding mortgage. Ignore interest. Purchase of a 2-year subscription to Businessweek magazine for $90 cash by Cindy Silverton. Purchase of used trucks by the U.S. Postal Service for $10 million cash from FedEx. The trucks were carried in the accounts at $10 million (original cost minus accumulated depreciation) by FedEx. Purchase of U.S. government bonds for $100,000 cash by Lockheed Corporation. Cash deposits of $18 on the returnable bottles sold by Safeway Stores to a retail customer, Philomena Simon. Collections on open account of $100 by an Office Depot store from a retail customer, Gerald Arrow. Purchase of traveler’s checks of $1,000 from American Express Company by William Spence. Cash deposit of $600 in a checking account in Bank of America by Jeffrey Hoskins. Purchase of a United Airlines “supersaver” airline ticket for $400 cash by Peter Tanlu on June 15. The trip will be taken on September 10.

 OBJECTIVES 3,4

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 OBJECTIVES 4, 5

2-57 Net Income and Retained Earnings McDonald’s Corporation is a well-known fast-food restaurant company. The following data are from its 2011 annual report ($ in millions): McDonald’s Corporation Retained earnings, December 31, 2010 Revenues

$33,811.7 27,006.0

Interest and other nonoperating expenses Provision for income taxes Food and paper expense Payroll and employee benefits

517.5 2,509.1 6,167.2 4,606.3

Dividends declared

$ 2,607.3

Selling, general, and administrative expenses Franchise restaurants—occupancy expenses Retained earnings, end of year

2,393.7 1,481.5 36,707.5

Occupancy and other operating expenses

3,827.6

1. Prepare the following for the year ended December 31, 2011: a. Income statement. Label the final three lines of the income statement as follows: income before provision for income taxes, provision for income taxes, and net income. b. The retained earnings column of the statement of stockholders’ equity. 2. Comment briefly on the relative size of the cash dividend.

 OBJECT IVES 4, 5

2-58 Earnings Statement, Retained Earnings General Mills, Inc. is a leading global manufacturer and marketer of branded consumer foods sold through retail stores and a supplier of branded and unbranded food products to the foodservice and commercial baking industries. The following amounts were in the financial statements contained in its annual report for the year ended May 29, 2011 ($ in millions): Total sales Cash Income taxes Accounts payable Total assets

$14,880.2 619.6 721.1 995.1 18,674.5

Retained earnings at beginning of year (June 1, 2010)

$8,122.4

Cost of sales Dividends declared Other expenses

8,926.7 729.4 3,434.1

Choose the relevant data and prepare (1) the income statement for the year and (2) the retained earnings column of the statement of stockholders’ equity for the year. Label the final three lines of the income statement as follows: income before income taxes, provision for income taxes, and net income.

 OBJECT IVE 6

2-59 Financial Ratios (Alternate is 2-60.) Following is a list of three well-known package delivery companies (UPS and FedEx from the United States and Deutsche Post World Net, owner of DHL, in Germany) and selected financial data of the sort typically included in letters sent by stock brokerage firms to clients. Note that € is the symbol for the euro, the European currency. Per Share Data Company

Price

FedEx UPS Deutsche Post

— $72.56 €11.88

Ratios and Percentages

Earnings

Dividends

$4.61 — € .96

— — —

P-E 20.3 18.7 —

Dividend-Yield

Dividend-Payout

— 2.9% —

10.4% — 72.7%

ASSIGNMENT MATERIAL

The missing figures for this schedule can be computed from the data given. 1. Compute the missing figures and identify the company with the following: a. The highest dividend-yield b. The highest dividend-payout percentage c. The lowest market price relative to earnings 2. Assume you know nothing about any of these companies other than the data given and the computations you have made from the data. Which company would you choose as a. the most attractive investment? Why? b. the least attractive investment? Why? 2-60 Financial Ratios (Alternate is 2-59.) Following is a list of three well-known petroleum companies and selected financial data of the sort typically included in letters sent by stock brokerage firms to clients. Per Share Data

 OBJECTIVE 6

Ratios and Percentages

Company

Price

Earnings

Dividends

P-E

Dividend-Yield

Dividend-Payout

Royal Dutch Shell

$36.45

$ 4.98

$1.68







ExxonMobil Chevron

$84.76 —

— $13.54

— —

10.05 7.86

2.2% —

— 22.8%

The missing figures for this schedule can be computed from the data given. 1. Compute the missing figures and identify the company with the following: a. The highest dividend-yield b. The highest dividend-payout percentage c. The lowest market price relative to earnings 2. Assume that you know nothing about any of these companies other than the data given and the computations you have made from the data. Which company would you choose as a. the most attractive investment? Why? b. the least attractive investment? Why? 2-61 Revenue Recognition and Ethics Diebold, Incorporated is an Ohio corporation that manufactures and sells automated teller machines (ATMs), bank security systems, and electronic voting machines. Its financial policies were called into question in May 2006 when the SEC opened an investigation into the company’s revenue recognition policies. From at least 2002 through 2007, Diebold recognized revenue on “F-term” orders, or Factory orders. In conjunction with many F-term orders, Diebold asked customers to sign a Memorandum of Agreement (MOA), which contained language stating that the customer had asked Diebold to hold the product for the customer’s convenience. Diebold typically recognized revenue on the “ship to warehouse” date specified in the MOA, when it shipped the product from the factory to a Diebold warehouse. However, in some instances Diebold shipped product to the warehouse before the specified ship to warehouse date. While the MOAs specified the ship to warehouse dates, they did not always include fixed dates when product was to be shipped from the Diebold warehouse to the end customer. In addition, at the time of shipment to the warehouse, some of the ATMs were not complete as software had not been installed and/or quality testing had not been completed. Comment on the ethical implications of Diebold’s revenue recognition practices.

 OBJECTIVE 2

2-62 Relevance and Faithful Representation Plum Creek Timber Company, Inc., is a Washington State forest products company. Its largest asset is Timber and Timberlands carried on its balance sheet at $3,377 million on December 31, 2011. This represents 79% of Plum Creek’s total assets. A footnote indicates that “timber and timberlands … are stated at cost.” This means that the book value of the land and timber is the cost Plum Creek paid for it whenever it purchased the property. Also on Plum Creek’s books are cash of $254 million; property, plant, and equipment of $138 million; and inventories of $53 million.

 OBJECTIVE 7

87

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CHAPTER 2 • MEASURING INCOME TO ASSESS PERFORMANCE

1. Does the timber and timberlands book value better meet the criterion of relevance or the criterion of faithful representation? Explain. 2. Plum Creek’s total assets are the sum of the book value of timber and timberlands; cash; property, plant, and equipment; inventories; and several other relatively small assets. What problem do you see with adding these amounts together when measuring total assets? 3. Is there an alternative measure of the timber and timberlands that might be more relevant than the original cost? If so, what is it? Would your measure meet the criterion of faithful representation as well as the original cost does?

 OBJECT IVE 8

2-63 Continuity Convention and Liquidation The following news report appeared in the financial press: The Bulgarian national airline Balkan is to be placed in liquidation after its creditors today rejected a reorganization plan, legal administrators for the carrier said. With debts of €92 million to 2,200 creditors, Balkan began bankruptcy procedures in March. Creditors today rejected a restructuring for the airline and insisted on the sale of its assets to pay off its debts. Explain how the measurements used in the financial statements of Balkan would differ from those used in a similar airline that had not been placed in liquidation.

Collaborative Learning Exercise  OBJECTIVE 6

2-64 Financial Ratios Form groups of four to six persons each. Each member of the group should pick a different company and find the most recent annual report for that company. 1. Members should compute the following ratios for their company: a. EPS b. P-E ratio c. Dividend-yield ratio d. Dividend-payout ratio 2. As a group, list two possible reasons that each ratio differs across the selected companies. Focus on comparing the companies with the highest and lowest values for each ratio, and explain how the nature of the company might be the reason for the differences in ratios.

Analyzing and Interpreting Financial Statements  OBJECT IVES 4, 5

2-65 Financial Statement Research Select the financial statements of any company. 1. What was the amount of sales (or total revenues) and the net income for the most recent year? 2. What was the total amount of cash dividends for the most recent year? 3. What was the ending balance in retained earnings in the most recent year? What were the two most significant items during the year that affected the retained earnings balance?

 OBJECTIVES 4, 5, 6

2-66 Analyzing Starbucks’ Financial Statements Find the Starbucks financial statements for 2011 either on Starbucks’ Web site or on the SEC’s EDGAR Web site and answer the following questions: 1. What was the amount of net revenues (total sales) and net earnings for the year ended October 2, 2011? 2. How did Starbucks’ net income and dividends affect its retained earnings? 3. What is Starbucks’ EPS for the year ended October 2, 2011? Compute the P-E ratio, assuming the market price for Starbucks’ stock was $35.93 at the time. 4. Suppose the average P-E ratio for companies at that time was 15. Do investors expect Starbucks’ EPS to grow faster or slower than average? Explain.

ASSIGNMENT MATERIAL

2-67 Analyzing Financial Statements Using the Internet: Time Warner Go to the Web site for Time Warner (www.timewarner.com). Click on Investor Relations. Find and open the most recent annual report. Answer the following questions: 1. Refer to Time Warner’s Statement of Income. What is the dollar amount of total revenues? What categories comprise its total revenues? Which category constitutes the largest percentage of total revenues? 2. Refer to Time Warner’s Notes to Consolidated Financial Statements. Locate the footnote containing discussion of Time Warner’s revenue recognition policies. Does Time Warner use a single revenue recognition policy to account for all of its different revenue generating activities? Find the portion of the footnote that discusses the revenue recognition policy for publishing activities. When does Time Warner recognize revenue from magazines? How does it account for subscriptions paid for in advance? 3. How much is Time Warner’s “unearned revenue”? What does it represent and where is it found in the financial statements? 4. Does Time Warner prepare its income statement using the cash or accrual basis? What items on the balance sheet are clues to answering this question? 5. Do you think Time Warner is a profit-seeking organization? What clues on the financial statements help you answer this?

89

 OBJECTIVES 1, 2, 3

3

Recording Transactions HAVE YOU EVER FLOWN ON Delta Air Lines? If so, your trip was just one of thousands of transactions that Delta had to record that day. With so many transactions happening, you might think that yours could get lost in the shuffle. Yet, you can read a report on your transaction combined with thousands of others in any major newspaper in articles based on press releases issued by the company. On April 26, 2011, Delta announced its earnings for the quarter ending March 2011. Here are some of the highlights of that announcement. Total operating revenue was $7.7 billion in the March 2011 quarter, up 13% compared to operating revenue of $6.8 billion in the March 2010 quarter. Both higher passenger revenue and higher cargo revenue contributed to the increase. Passenger revenue rose 13%, or $769 million, and cargo revenue rose 42%, or $74 million. The increase in both revenue categories was attributable to higher volume and higher yields, despite the impact of severe winter weather and the catastrophic earthquake in Japan. Ed Bastian, Delta’s president, said that the company expected double-digit unit revenue growth in the quarter ending June 2011. Despite increased revenue, the company reported a net loss of $318 million for the quarter, $128 million worse than the net loss reported in the comparable quarter of 2010. The $610 million impact of 30% higher fuel prices was a major contributor to the weak income performance. Richard Andrew, Delta’s CEO, commented that fuel costs are the biggest challenge facing the airline industry. Delta is engaged in numerous actions including fuel hedging, capacity reductions and changes in cost structure in an effort to offset the impact of fuel prices on net income. Are you not seeing that trip to Disney World you took? The information contained in this news article comes directly from Delta’s corporate headquarters and informs investors, stockholders, and other interested parties about the financial performance of the organization. Delta’s corporate headquarters gets this information from the company’s accounting records. Of course, these records contain every single Delta transaction, including your Disney World trip. Delta’s transactions can take many forms—for example, sale of tickets to passengers, sale of cargo transportation services, purchase of fuel for the planes, and payment of wages to employees. At the end of the month, quarter, or year, accountants compute the totals for each account and use them to prepare the reports that tell the financial story for that period. As you can see from Delta’s press release, total operating revenue for the March 2011 quarter was $7.7 billion. After deducting expenses and other items, the net loss was $318 million. This indicates that, on average, Delta lost $.041 on each dollar of operating revenue [($318) million ÷ $7,700 million]. Information in press releases often leads to price changes in a company’s stock. Delta’s share price jumped by 7.3% on the day of the earnings announcement and increased by 12.35%

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Use double-entry accounting. 2 Describe the five steps in the recording process. 3 Analyze and journalize transactions and post journal entries to the ledgers.

4 Prepare and use a trial balance. 5 Close revenue and expense accounts and update retained earnings. 6 Correct erroneous journal entries and describe how errors affect accounts.

7 Explain how computers have transformed the processing of accounting data.

during the week following the announcement, to close at $10.46. The earnings release contained significant information and caused investors to change their valuation of Delta’s shares. The investors viewed the press release as good news, despite the net loss and poor performance relative to the prior year. What could cause this positive response to seemingly negative news? While the company reported a net loss of $.38 per share, the analysts’ estimate of EPS was a loss of $.50 per share. Delta outperformed the market’s expectation. In addition, the company provided guidance that the coming quarter would bring higher revenues and controlled costs, leading to an expectation of better times ahead. All companies, including Delta, have to develop systems for processing huge volumes of accounting data. Methods of processing the data have changed dramatically over time because computerized systems have replaced manual ones. However, the steps in recording, storing, and processing accounting data have not changed. Switching from pencil-and-paper accounting records to computerized ones is a little like switching from a car with a stick shift to one with an automatic transmission. You spend less time worrying about routine tasks, but you still need to understand how to use the vehicle. Whether a company enters data into the system by pencil, keyboard, or optical scanner, it must enter, summarize, and report the same basic data, and users must interpret the same basic financial statements.

What started as a crop dusting operation in 1924 has become one of the world’s largest global airlines. Each year, more than 160 million travelers fly on Delta or one of its affiliated airlines. Delta must record millions of sales transactions each year. These transactions provide the basic information for the company’s financial statements.

To intelligently use the financial statements you learned about in the last two chapters, decision makers need to understand the methods accountants use to record and analyze the data in those statements. This chapter focuses on those methods. In particular, this chapter explains the double-entry accounting system that all companies use to record and process information about their transactions. As you will discover, a working knowledge of this system is essential for anyone engaged in business. Ultimately, accounting practices constitute a language that managers in all organizations use to understand the economic progress of their organizations.



91

92

CHAPTER 3 • RECORDING TRANSACTIONS

 OBJECT IVE 1 Use double-entry accounting.

double-entry system The method usually followed for recording transactions, whereby every transaction affects at least two accounts.

The Double-Entry Accounting System In large businesses such as Delta Air Lines, McDonald’s, and Verizon, hundreds or thousands of transactions occur hourly. With so much activity, it might seem easy to lose track of one or two transactions. Even one lost transaction could create havoc on a company’s accounting (just think of what happens when you miss one transaction in your checking account record). Such errors may lead to serious consequences. As a result, accountants must record these transactions in a systematic manner. Worldwide, the dominant recording process is a double-entry system, in which every transaction affects at least two accounts. Accountants analyze each transaction to determine which accounts it affects, whether to increase or decrease the account balances, and how much each balance will change. Accountants have used such a system for more than 500 years, as described in the Business First box on p. 93. Recall the first three transactions of the Biwheels Company introduced in Chapter 1:

Cash (1) Initial investment by owner (2) Loan from bank (3) Acquire store equipment for cash

general journal A complete chronological record of an organization’s transactions and how each transaction affects the balances in particular accounts.

general ledger The collection of all ledger accounts that supports an organization’s financial statements.

ledger account A listing of all the increases and decreases in a particular account.

T-account Device used to portray the individual ledger accounts in the general ledger. Each T-account takes the form of the capital letter T and represents an individual ledger account. We accumulate the transactions that affect a particular ledger account within the related T-account.

balance A numerical total that is the net result of all activity recorded in an account as of a particular point in time. In a T-account the balance is the difference between the total leftside and right-side amounts in the T-account at any particular time. The balance in a general ledger account at the end of an accounting period is computed as the beginning balance in the account, plus the amount of the increases in the account during the period, minus the amount of the decreases.

+400,000 +100,000 –15,000

A +

Store Equipment

+15,000

= = = = =

L Note Payable

+ +

SE Paid-in Capital +400,000

+100,000

This balance sheet equation format illustrates the basic concepts of the double-entry system by showing two entries for each transaction. It also emphasizes that the equation Assets = Liabilities + Stockholders’ Equity must always remain in balance. Unfortunately, this format is too cumbersome for recording each and every transaction that occurs. In practice, accountants record the individual transactions as they occur and then organize the elements of the transaction into accounts that group similar items together. For example, the Cash account collects all elements that affect cash. The remainder of this chapter describes the elements of a double-entry system, focusing on how accountants use general journals and general ledgers to record, summarize, and report financial information. The general journal is a chronological record of an organization’s transactions and how each transaction affects the balances in particular accounts. The general ledger is a collection of all ledger accounts that supports the organization’s financial statements, where a ledger account is a listing of all the increases and decreases in a particular account. Let’s begin with the general ledger.

The General Ledger The general ledger traditionally was a bound or loose-leaf book of ledger accounts, but today it is more likely to be a set of records in an electronic file. However, for simplicity’s sake, you can think of the general ledger as a book with one page for each account. When you hear about “keeping the books” or “auditing the books,” the word books refers to the general ledger, even if it is an electronic file. Accountants always keep the ledger accounts current in a systematic manner. We use T-accounts to portray the individual ledger accounts in the general ledger. We call them T-accounts because they take the form of the capital letter T. Each T-account represents an individual account, such as Cash, Receivables, or Inventory. Within a T-account we accumulate the transactions that affect that particular ledger account. The vertical line in the T divides the account into left and right sides. Increases in the account go on one side of the vertical line and decreases on the other. The account title is shown on the horizontal line of the T. Consider the format of the Cash T-account: Cash Left side Increases in cash

Right side Decreases in cash

We record increases in asset accounts (such as Cash) on the left side of the T-account and decreases on the right side. We reverse this process for liabilities and owners’ equity accounts—increases go on the right and decreases on the left. The balance in an account is the net result of all activity that has been recorded in the account as of a particular point in time. The balance in a T-account is

THE DOUBLE-ENTRY ACCOUNTING SYSTEM

93

BUSINESS FIRST DOUBLE-ENTRY ACCOUNTING: FIVE CENTURIES OF PROGRESS Double-entry accounting is more than 500 years old. In the same decade that Columbus set sail for America, Luca Pacioli, an Italian friar and mathematician, published Summa de Arithmetica, Geometria, Proportioni, et Proportionalita (“Everything About Arithmetic, Geometry, and Proportions”), the first book that described a double-entry accounting system. Pacioli did not invent accounting. He simply described the system used by Venetian merchants. His system included journals and ledgers, with accounts for assets (including receivables and inventories), liabilities, equity, income, and expenses. His process included closing the books and preparing a trial balance. All these terms and concepts are still in use today, as described in this chapter. Pacioli also warned that “a person should not go to sleep at night until the debits equaled the credits,” a good warning for accountants today. The last five decades have seen more changes in accounting than did the preceding five centuries. First, automated data processing started replacing manual accounting systems. This, combined with the growth of complex business transactions, made accounting transactions more difficult and less transparent to financial statement users. Then a knowledge-based economy called into question an accounting system that focused mainly on physical assets. The accounting scandals of the early twenty-first century put double-entry accounting at a crossroads. First, problems at Enron, WorldCom, Global Crossing, Tyco,

Adelphia, and others caused critics to question the relevance of accounting in the modern business world. How could companies that had been reporting healthy financial results suddenly plunge into financial distress? Then some pundits blamed the financial crisis of 2008–2009 and the failure of companies such as AIG, Bear Stearns, and Merrill Lynch on financial reporting rules, especially the accounting for financial instruments. It is clear that reliable accounting systems are more important than ever. The discipline of a double-entry system cannot prevent managers and accountants from making bad decisions or entering fraudulent transactions in a company’s books, but it does provide a framework for reporting economic results that is essential for disclosing information about a company to investors and potential investors. In the 1920s, Werner Sombart, a German accountant, made the case that double-entry accounting played a major role in the development of capitalistic, marketbased economies. This is reinforced in a recent book, Double Entry: How the Merchants of Venice Created Modern Finance. The events of the last decade prove its importance to the smooth functioning of worldwide capital markets. From Pacioli’s time until today, double-entry accounting systems have kept confirming their value. To understand a market economy, one must understand the basics of double-entry accounting. Sources: L. Pacioli, Summa de Arithmetica, Geometria, Proportioni, et Proportionalita, 1494; W. Sombart, Der Moderne Kapitalismus, 1924, and J. Gleeson-White, Double Entry: How the Merchants of Venice Created Modern Finance, W. W. Norton & Company, 2012.

the difference between the total left-side and right-side amounts in the T-account at any particular time. Asset accounts have left-side balances, that is, the total of the entries on the left side will be larger than the total of the entries on the right. In contrast, liability and owners’ equity accounts have right-side balances. The balance in a general ledger account at the end of an accounting period is computed as the beginning balance in the account, plus the amount of the increases in the account during the period, minus the amount of the decreases. The T-accounts for the first three Biwheels Company transactions are as follows: Assets

=

Liabilities + Stockholders’ Equity

Cash Increases (1) 400,000 (2)

Note Payable Decreases (3) 15,000

Decreases

100,000 Store Equipment

Increases (3)

Increases (2) 100,000

Decreases 15,000

Paid-in Capital Decreases

Increases (1) 400,000

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CHAPTER 3 • RECORDING TRANSACTIONS

Note that each of the three numbered transactions affects two accounts. Remember that, under the double-entry system, each transaction will affect at least two accounts so that the balance sheet is always in balance. In practice, we create accounts as we need them. We call the process of creating a new T-account in preparation for recording a transaction “opening the account.” For transaction 1, we opened Cash and Paid-in Capital. For transaction 2, we opened Note Payable, and for transaction 3, we opened Store Equipment. We know that we need a new account when a transaction requires an entry to an account that we have not yet opened. Each T-account summarizes the changes—increases and decreases—in a particular asset, liability, or owners’ equity account. Because T-accounts show only amounts and not transaction descriptions, we identify each transaction in some way, such as by the numbering used in this illustration, by the date, or by both. This identification helps us to link the ledger entry to the transaction that caused it. Take a look at the analysis of the entries for each Biwheels transaction. Notice that each transaction generates a left-side entry in one T-account and a right-side entry of the same amount in another T-account. When you analyze a transaction, it is helpful to initially pinpoint the effects (if any) on cash. Did cash increase or decrease? Then think of the effects on other accounts. It is frequently easier to identify the effects of a transaction on the Cash account than it is to identify the effects on other accounts. 1. Transaction: Analysis:

Initial investment by owners, $400,000 cash. The asset Cash increases. The stockholders’ equity Paid-in Capital increases. Cash

(1)

Paid-in Capital

400,000

2. Transaction: Analysis:

(1)

Loan from bank, $100,000. The asset Cash increases. The liability Note Payable increases. Cash

(1) (2)

Note Payable

400,000 100,000

3. Transaction: Analysis:

(2)

100,000

Acquired store equipment for cash, $15,000. The asset Cash decreases. The asset Store Equipment increases. Cash

(1) (2)

400,000

400,000 100,000

(3)

Store Equipment 15,000

(3)

15,000

Ledger accounts contain a record of all the changes in specific assets, liabilities, and owners’ equity. Accountants can prepare financial statements at any point in time if the account balances are up-to-date. The ledger accounts provide the information needed for the preparation of financial statements. For example, Biwheels’ balance sheet after its first three transactions would contain the following account balances: Liabilities and Stockholders’ Equity

Assets Cash Store equipment

Total

$485,000 15,000

$500,000

Liabilities Note payable Stockholders’ equity Paid-in capital Total

$100,000 400,000 $500,000

DEBITS AND CREDITS

95

Because Biwheels has just begun operations, there are no carry-over balances from the end of the previous accounting period. In the case of Store Equipment, Note Payable, and Paid-in Capital, there has been only one transaction up to this point, so the transaction amount becomes the account balance. For Cash, the balance of $485,000 is the difference between the total increase on the left side of ($400,000 + $100,000) = $500,000 and the total decrease of $15,000 on the right side.

Debits and Credits You have just seen that the double-entry system features entries on left sides and right sides of various accounts. Accountants use the term debit (abbreviated dr.) to denote an entry or balance on the left side of any account and the term credit (abbreviated cr.) to denote an entry or balance on the right side. Popular usage ascribes other meanings to debit and credit, but in accounting they mean simply left-side entry and right-side entry. Some accountants use the word charge instead of debit, but there is no such synonym for credit. Just remember that debit refers to left and credit refers to right, and you will be fine. Accountants use debit and credit as verbs, adjectives, and nouns. “Debit $1,000 to Cash” and “credit $1,000 to Accounts Receivable” are examples using debit and credit as verbs, meaning that you should place $1,000 on the left side of the Cash account and on the right side of the Accounts Receivable account. In “make a debit to Cash,” debit is a noun, and in “Cash has a debit balance of $12,000,” it is an adjective describing the balance. From this point on you will see the terms debit and credit again and again. Be sure you understand their uses completely before moving on.

Summary Problem for Your Review PROBLEM Suppose Biwheels’ accountant asked you to do the following: “Debit Note Payable for $5,000 and credit Cash for $5,000.” 1. Describe the transaction the accountant is asking you to record. 2. What are the balances in Cash and Note Payable after you record this transaction? Before the transaction the Cash balance was $486,000 and the Note Payable balance was $100,000. 3. After you correctly make the entries, the accountant tells you “I give you credit for correctly carrying out my instructions. If you had failed, it would be a debit on your record.” What does she mean by “credit” and “debit” in this situation?

SOLUTION 1. Debiting the Note Payable account means to record an entry for $5,000 on the left side of the T-account. This decreases the Note Payable balance by $5,000 because Note Payable is a liability account. Crediting Cash for $5,000 means a right-hand entry to the Cash T-account, decreasing the balance in that asset account. Cash and Note Payable both decrease by $5,000, so the transaction represents a repayment of $5,000 of the note payable. 2. The Cash account will decrease by $5,000 to ($485,000 – $5,000) = $480,000. The Note Payable account will also decrease by $5,000 to ($100,000 – $5,000) = $95,000. 3. These are popular uses of the terms credit and debit—credit meaning praise or recognition and debit meaning blame. These definitions have nothing to do with the accounting uses of the terms. Remember, in accounting debit means left side and credit means right side, nothing more.

debit An entry or balance on the left side of any account.

credit An entry or balance on the right side of any account.

charge A word often used instead of debit.

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CHAPTER 3 • RECORDING TRANSACTIONS

The Recording Process OBJECTIVE 2 Describe the five steps in the recording process.

In the preceding section, we entered Biwheels’ transactions 1, 2, and 3 directly in the ledger accounts. In actual practice, accountants first record transactions in the general journal. The sequence of five steps in recording and reporting transactions is as follows:

Transaction Documentation

Journal

Ledger

Trial Balance

Financial Statements

Step 1

Step 2

Step 3

Step 4

Step 5

source documents The original records supporting any transaction.

book of original entry Another name for the general journal.

Step 1: The recording process begins with source documents. These are the original records supporting any transaction. Examples of source documents include sales slips or invoices, check stubs, purchase orders, receiving reports, cash receipt slips, and minutes of the board of directors. Most transactions generate a source document. For example, when a company sells a product to a customer, it creates a receipt for the sale. Companies keep source documents on file so they can use them to verify the details of a transaction and the accuracy of subsequent records, if necessary. Step 2: In the second step of the recording process, we place an analysis of the transaction, based on the source documents, in the general journal, also called the book of original entry. Recall that the general journal is a chronological listing of transactions. It is basically a diary of all events (transactions) in an entity’s life. Step 3: The third step is to enter transactions into the ledger accounts. As we have seen, we enter each component into the left side or the right side of the appropriate accounts.

trial balance A list of all the accounts in the general ledger together with their balances.

Step 4: The fourth step is the preparation of the trial balance, which is a list of all the accounts in the general ledger together with their balances. This list aids in verifying clerical accuracy and in preparing financial statements. Thus, we prepare it as needed, perhaps each month or each quarter as the firm prepares its financial statements. The timing of the first four steps varies. Transactions occur constantly so companies prepare source documents continuously. Depending on the size and nature of the organization, transaction summaries may occur continuously, weekly, or monthly. The timing of the steps in the recording process must conform to the needs of the users of the data. Step 5: The final step, closing the books and preparing financial statements, occurs at least once a quarter, every 3 months, for publicly traded companies in the United States and at least annually for those reporting under IFRS. However, most companies prepare financial statements more frequently for management’s benefit. For example, Springfield ReManufacturing Corporation, an employee-owned company in southern Missouri with more than 1,200 employees and sales of more than $400 million, prepares monthly financial statements. Springfield is a leader in “open book management,” in which the company opens its accounting results to everyone in the firm. Management and all employees meet monthly to examine the results in detail. The company provides extensive training to employees on how the accounting process works and what the numbers mean. This management process has focused the attention of every employee and increased efficiency and profitability at Springfield.

Chart of Accounts chart of accounts A numbered or coded list of all account titles.

To ensure consistency in recording transactions, organizations specify a chart of accounts, which is a numbered or coded list of all account titles. This list specifies the accounts that the organization uses in recording its activities and is usually arranged in the order in which accounts

THE RECORDING PROCESS

97

appear in the financial statements. Accountants often use these account numbers as a shorthand way to identify the accounts. The following is the chart of accounts for Biwheels: Account Number 100 120 130 140 170 170A

Account Title

Account Number

Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment Accumulated depreciation, store equipment (explained later)

202 203 300 400 500 600 601 602

Account Title Note payable Accounts payable Paid-in capital Retained earnings Sales revenue Cost of goods sold Rent expense Depreciation expense

There is no universally agreed upon chart of accounts. The chart varies across companies as a function of the size, nature, and complexity of the organization. Large companies may have thousands of account numbers.

Journalizing Transactions Let’s examine step 2 in the recording process more closely. We call this step journalizing— the process of entering transactions into the general journal. A journal entry is an analysis of the effects of a single transaction on the various accounts, usually accompanied by an explanation. For each transaction, this analysis identifies the accounts to be debited and credited. The top of Exhibit 3-1 shows how to journalize the opening three transactions for Biwheels. We will use the following conventions for recording journal entries in the general journal: 1. The date and identification number of the entry make up the first two columns. 2. The next column, Accounts and Explanation, shows the names of the accounts affected. At the left margin we place the title of the account or accounts to be debited. We indent the title of the account or accounts to be credited. Following the journal entry itself is the narrative explanation of the transaction. The length of the explanation depends on the complexity of the transaction and whether management wants the journal itself to contain all relevant information. Most often, explanations are brief because details are available in the supporting documents. 3. The Post Ref. (posting reference) column contains an identifying number from the chart of accounts that we use for cross-referencing to the ledger accounts. 4. The debit and credit columns show the amounts that we debit (left-entry) or credit (rightentry) to each account. It is customary not to use currency symbols (for example, dollar signs or yen or euro symbols) in either the journal or the ledger. Negative numbers never appear in the journal or the ledger. Instead, the side on which the number appears tells you whether to add or subtract the number in computing an account balance. Debits and credits tell the whole story in the recording process, so be sure you understand them fully. Accountants often become so familiar with the various codes used in their company’s chart of accounts that they think, talk, and write in terms of account numbers instead of account names. Thus, they might journalize Biwheels’ entry 3, the acquisition of Store Equipment (Account 170) for Cash (Account 100), as follows: 20X2 Jan. 3

170 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 . . . . . . . . . . . . . . . . . . . . . . . . .

dr. 15,000

cr. 15,000

This journal entry employs the accountant’s shorthand, which uses codes without account names. Its brevity and lack of explanation would hamper any outsider’s understanding of the transaction, but the entry’s meaning would be clear to any accountant within the organization.

OBJECTIVE 3 Analyze and journalize transactions and post journal entries to the ledgers.

journalizing The process of entering transactions into the general journal.

journal entry An analysis of the effects of a transaction on the various accounts, usually accompanied by an explanation.

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CHAPTER 3 • RECORDING TRANSACTIONS

EXHIBIT 3-1 Biwheels Company Journal Entries—Recorded in the General Journal and Posted to the General Ledger

General Journal

Date

Entry No.

20X2 1/2

1

1/2

20X2 1/3

2

3

Accounts and Explanation

Post Ref.

Debit

Cash Paid-in capital Capital stock issued to Lopez

100 300

400,000

Cash Note payable Borrowed at 9% interest on a one year note.

100 202

100,000

Store equipment Cash Acquired store equipment for cash.

170 100

15,000

Credit

400,000

100,000

15,000

General Ledger CASH Date 20X2 1/2

1/2

Explanation (often blank because the explanation is already in the journal)

Journ. Ref.

Debit

Date

1

400,000

20X2 1/3

2

100,000

STORE EQUIPMENT Date

Explanation

20X2 1/3

Journ. Ref.

Debit

3

15,000

Date

NOTE PAYABLE Date

Explanation

Journ. Ref.

Debit

Date

Account No.

Explanation

Date

Explanation

Journ. Ref.

Debit

Date 20X2 1/2

Credit

3

15,000

Journ. Ref.

Account No.

Explanation

20X2 1/2

PAID-IN CAPITAL

Journ. Ref.

Account No.

Explanation

170

Credit

202

Journ. Ref.

Credit

2

100,000

Account No.

Explanation

100

300

Journ. Ref.

Credit

1

400,000

Posting Transactions to the General Ledger posting The transferring of amounts from the general journal to the appropriate accounts in the general ledger.

We call step 3, the transferring of amounts from the general journal to the appropriate accounts in the general ledger, posting. To see how this works, consider transaction 3 for Biwheels as depicted in Exhibit 3-1. The red arrows in Exhibit 3-1 show how we post the $15,000 credit to the general ledger Cash account using the information and values from the journal entry recorded in the general journal. Note that the format of the sample general ledger in Exhibit 3-1 provides space for transferring all the information in the journal entry, not just the summary information allowed in the simplified T-account format. There are columns for dates, explanations, journal

ANALYZING, JOURNALIZING, AND POSTING THE BIWHEELS TRANSACTIONS

99

EXHIBIT 3-2 Biwheels Company Account No.

Cash

Journ. Ref. Debit

Date

Explanation

20X2 1/2 1/2 1/3

(often blank because the explanation is already in the journal)

1 2 3

100

Credit

Balance

15,000

400,000 500,000 485,000

400,000 100,000

references, and amounts. The structure is repeated for debits on the left side of the page and for credits on the right side. Because posting is strictly a mechanical process of moving numbers from the general journal to the general ledger, it is most efficiently done by a computer. The accountant journalizes a transaction in an electronic general journal, and the computer automatically transfers the information to an electronic version of the general ledger. There is also cross-referencing between the general journal and the general ledger. Cross-referencing is the process of using numbering, dating, and/or some other form of identification to relate each general ledger posting to the appropriate journal entry. A single transaction from the general journal might be posted to several different ledger accounts. Cross-referencing allows users to find all the components of the transaction in the general ledger no matter where they start. It also helps auditors to find and correct errors and reduces the frequency of errors. General ledger entries do not always take the form of Exhibit 3-1. Exhibit 3-2 shows another popular general ledger format, one that has only one date column and one explanation column and adds an additional column to the presentation to provide a running balance of the account holdings. This format is very similar to the format found in a checkbook. The running balance feature is a useful addition because it provides a status report for an account at a glance. Although most accounting systems are now fully computerized, the reports generated by computers often look much like the paper-based general ledgers and general journals they replaced. After hundreds of years of use, these formats have become traditional and familiar.

Analyzing, Journalizing, and Posting the Biwheels Transactions We have seen that accountants review source documents about a transaction, mentally analyze the transaction, record that analysis in a journal entry in the general journal, and then post the results to the general ledger. We can now apply this process to additional transactions from the Biwheels Company. We will omit explanations for the journal entries because we already presented them in the original statement of the transaction. We indicate the posting of the elements of the transaction to the T-accounts by encircling the new number. 4. Transaction: Analysis: Journal Entry:

Acquired merchandise inventory for cash, $120,000. The asset Merchandise Inventory increases. The asset Cash decreases. Merchandise inventory. . . . . . . . . . . . . . . . . 120,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . .

120,000

Posting: Cash (1) (2)

400,000 100,000

(3) (4)

Merchandise Inventory 15,000 120,000

(4)

120,000

Ledger Account with Running Balance Column

cross-referencing The process of using numbering, dating, and/or some other form of identification to relate each general ledger posting to the appropriate journal entry.

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CHAPTER 3 • RECORDING TRANSACTIONS

5. Transaction: Analysis: Journal Entry:

Acquired merchandise inventory on credit, $10,000. The asset Merchandise Inventory increases. The liability Accounts Payable increases. Merchandise inventory . . . . . . . . . . . . . . . . 10,000 Accounts payable . . . . . . . . . . . . . . . . . 10,000

Posting: Merchandise Inventory (4) (5) simple entry A journal entry for a transaction that affects only two accounts.

Accounts Payable

120,000 10,000

(5)

10,000

Transaction 5, like transactions 1, 2, 3, and 4, is a simple entry because the transaction affects only two accounts. Note that the balance sheet equation remains in balance with each new transaction. 6. Transaction: Analysis:

Journal Entry:

Acquired merchandise inventory for $10,000 cash plus $20,000 trade credit. The asset Cash decreases. The asset Merchandise Inventory increases. The liability Accounts Payable increases. Merchandise inventory . . . . . . . . . . . . . . . . 30,000 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 Accounts payable . . . . . . . . . . . . . . . . . 20,000

Posting: Cash (1) (2)

400,000 100,000

(3) (4) (6)

Accounts Payable 15,000 120,000 10,000

(5) (6)

10,000 20,000

Merchandise Inventory (4) (5) (6) compound entry A journal entry for a transaction that affects more than two accounts.

120,000 10,000 30,000

Transaction 6 is a compound entry, which means that a single transaction affects more than two accounts. Whether transactions are simple (like transactions 1 through 5) or compound, the total of all left-side entries always equals the total of all right-side entries. The net effect is to keep the accounting equation in balance at all times: Assets = Liabilities + Stockholders’ equity + 30,000 - 10,000 = +20,000 7. Transaction: Analysis: Journal Entry:

Sold unneeded showcase to neighbor for $1,000 cash. The cost of the showcase was $1,000. The asset Cash increases. The asset Store Equipment decreases. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 Store equipment . . . . . . . . . . . . . . . . . 1,000

Posting: Cash (1) (2) (7)

400,000 100,000 1,000

(3) (4) (6)

Store Equipment 15,000 120,000 10,000

(3)

15,000 (7)

1,000

ANALYZING, JOURNALIZING, AND POSTING THE BIWHEELS TRANSACTIONS

101

In transaction 7, one asset increases, and another asset decreases. The transaction affects only one side of the accounting equation because there is no entry to a liability or stockholders’ equity account. 8. Transaction: Analysis: Journal Entry:

Returned merchandise inventory to supplier for full credit, $800. The asset Merchandise Inventory decreases. The liability Accounts Payable decreases. Accounts payable . . . . . . . . . . . . . . . . . . . . 800 Merchandise inventory . . . . . . . . . . . . . 800

Posting: Merchandise Inventory (4) (5) (6)

120,000 10,000 30,000

9. Transaction: Analysis: Journal Entry:

(8)

Accounts Payable 800

(8)

800

Paid cash to creditor, $4,000. The asset Cash decreases. The liability Accounts Payable decreases. Accounts payable . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . .

(5) (6)

10,000 20,000

4,000 4,000

Posting: Cash (1) (2) (7)

400,000 100,000 1,000

(3) (4) (6) (9)

Accounts Payable 15,000 120,000 10,000 4,000

(8) (9)

800 4,000

(5) (6)

10,000 20,000

Transactions 7, 8, and 9 are all simple entries. In transactions 8 and 9, an asset and a liability both decrease an equal amount, retaining the equality of the balance sheet equation.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Accountants are precise in their use of the words debit and credit. However, managers sometimes are not as careful. Critique the following statements by a manager. 1. We need to charge that account, so make a credit to it. 2. Debit and credit seem to mean different things to different companies. One company’s debit is often another company’s credit.

Answer 1. This statement is internally inconsistent. Charge, debit, and left side are synonyms. You cannot both charge and credit an account. 2. This statement can be true in certain situations. The clearest example is probably the sale of merchandise on open account. The buyer’s Account Payable would have a credit (right) balance, and the seller’s Account Receivable would have a debit (left) balance.

Revenue and Expense Transactions Revenue and expense transactions deserve special attention because their relationship with the balance sheet equation is less obvious. Recall that the stockholders’ equity section of the balance sheet equation includes both Paid-in Capital and Retained Earnings: Assets = Liabilities + Stockholders’ equity Assets = Liabilities + (Paid-in capital + Retained earnings)

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CHAPTER 3 • RECORDING TRANSACTIONS

Also, recall from Chapter 2 that, if we ignore dividends, retained earnings is merely accumulated revenue less accumulated expenses. Therefore, we can group the T-accounts as follows: Assets + Debit

=

Liabilities

– Credit

– Debit

+

+ Credit

Paid-in Capital – Debit

+ Retained Earnings

+ Credit

– Debit

Expenses

+ Credit

Revenues

+ Debit

+ Credit

Revenues and expenses are part of retained earnings. You can think of them as separate compartments within the larger Retained Earnings account. Why don’t we simply increase or decrease the Retained Earnings account directly, eliminating the need for separate Revenue and Expense accounts? To do so would make it more difficult to prepare an income statement because revenue and expense items would be mixed together in the Retained Earnings account. By accumulating information separately for categories of revenue and expense, we simplify the preparation of an income statement. A revenue account accumulates items that increase retained earnings. Any credit to revenue is effectively a credit to retained earnings. Therefore, when we record Sales Revenue, we increase both revenues and retained earnings. Similarly, an expense account accumulates items that decrease retained earnings. A debit to expense is effectively a debit to retained earnings. Although a debit entry increases expenses, it results in a decrease in retained earnings. Thus, when we record Wage Expense, we increase expenses but decrease retained earnings. Revenue and expense accounts are fundamentally a part of stockholders’ equity. We can now examine a few transactions involving revenues and expenses. Consider Biwheels’ transactions 10a and 10b: 10a. Transaction: Analysis:

Journal Entry:

Sales on credit, $160,000. The asset Accounts Receivable increases. Stockholders’ equity, specifically Retained Earnings, increases because a revenue account, Sales Revenue, increases. Accounts receivable. . . . . . . . . . . . . . . . . . . Sales revenue . . . . . . . . . . . . . . . . . . .

160,000 160,000

Posting: Accounts Receivable (10a)

Sales Revenue

160,000

(10a)

160,000

A credit, or right-side, entry in transaction 10a increases the Sales Revenue account, increasing the stockholders’ equity account, Retained Earnings. In transaction 10b, a debit, or left-side, entry increases the expense account, Cost of Goods Sold. The effect is to decrease the stockholders’ equity account, Retained Earnings. 10b. Transaction: Analysis:

Journal Entry:

Cost of merchandise inventory sold, $100,000. The asset Merchandise Inventory decreases. Stockholders’ equity, specifically Retained Earnings, decreases because an expense account, Cost of Goods Sold, increases. Cost of goods sold . . . . . . . . . . . . . . . . . . . 100,000 Merchandise inventory . . . . . . . . . . . . . . 100,000

Posting: Merchandise Inventory (4) (5) (6)

120,000 10,000 30,000

(8) (10b)

Cost of Goods Sold 800 100,000

(10b)

100,000

ANALYZING, JOURNALIZING, AND POSTING THE BIWHEELS TRANSACTIONS

Before we continue, let’s look for a minute at the logic illustrated by transactions 10a and 10b. These transactions illustrate the relationship of revenue and expense to retained earnings. Revenues increase Retained Earnings, a stockholders’ equity account, because the revenue accounts and the stockholders’ equity accounts are right-side balance accounts. Expenses decrease Retained Earnings because expenses are left-side balance accounts. They reduce the normal right-side balance of Retained Earnings. Therefore, increases in expenses are decreases in Retained Earnings and thereby in stockholders’ equity. The following analysis shows that we could record the $160,000 in Sales Revenue and $100,000 in Cost of Goods Sold expense directly to the Retained Earnings account or first in separate revenue and expense accounts that are part of Retained Earnings. The latter alternative captures the most information and is the preferred approach. If direct to Retained Earnings:

Paid-in Capital Decreases

Retained Earnings

Increases

Decreases 100,000

Increases 160,000

If we create revenue and expense accounts Expenses that we will eventually summarize into a Increases single net effect on retained earnings: 100,000

Revenues Increases 160,000

Exhibit 3-3 presents the rules of debit and credit and the normal balances of the accounts discussed in this section. It demonstrates the basic principles of the balance sheet equation and the double-entry accounting system: Left side = Right side Debit = Credit The exhibit also emphasizes that revenues increase stockholders’ equity. Therefore, we record them as credits. In contrast, expenses decrease stockholders’ equity, and we record them as debits. Keeping separate accounts for revenues and expenses makes it easier to prepare an income statement. Revenues and expenses comprise the data used to calculate net income (or net loss) on the income statement, thereby providing a detailed explanation of how the period’s transactions caused the balance sheet account, Retained Earnings, to change during the period. EXHIBIT 3-3 Rules of Debit and Credit and Normal Balances of Accounts Rules of Debit and Credit Assets Assets + – Increase Decrease Debit Credit Left Right Normal Bal.

= =

Liabilities

+

Liabilities – + Decrease Increase Debit Credit Left Right Normal Bal.

+

Stockholders’ Equity Paid-in Capital – + Decrease Increase Debit Credit Left Right Normal Bal. Expenses +* – Increase Decrease Debit Credit Left Right Normal Bal.

+

Retained Earnings – + Decrease Increase Debit Credit Left Right Normal Bal.

– Decrease Debit Left

Revenues + Increase Credit Right Normal Bal.

*Remember that increases in expenses decrease retained earnings.

Normal Balances Assets Liabilities Stockholders’ equity (overall) Paid-in capital Revenues Expenses

Debit Credit Credit Credit Credit Debit

103

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CHAPTER 3 • RECORDING TRANSACTIONS

Transaction 11 is the collection of some of the accounts receivable created by transaction 10a: 11. Transaction: Analysis: Journal Entry:

Cash collected from debtors, $5,000. The asset Cash increases. The asset Accounts Receivable decreases. Cash ......................................................... Accounts receivable ............................

5,000 5,000

Posting: Cash (1) (2) (7) (11)

400,000 100,000 1,000 5,000

(3) (4) (6) (9)

Accounts Receivable 15,000 120,000 10,000 4,000

(10a)

160,000 (11)

5,000

Prepaid Expenses and Depreciation Transactions Recall from Chapter 2 that prepaid expenses, such as prepaid rent and depreciation expense, relate to assets having a useful life that will expire in the future. Biwheels’ transactions 12, 13, and 14 demonstrate the journalizing and posting of prepaid rent expenses and depreciation of store equipment. 12. Transaction: Analysis: Journal Entry:

Paid rent for 3 months in advance, $6,000. The asset Cash decreases. The asset Prepaid Rent increases. Prepaid rent .............................................. Cash ................................................

6,000 6,000

Posting: Cash (1) (2) (7) (11)

400,000 100,000 1,000 5,000

(3) (4) (6) (9) (12)

Prepaid Rent 15,000 120,000 10,000 4,000 6,000

(12)

6,000

Transaction 12 represents the prepayment of rent as the acquisition of an asset. It affects only asset accounts—Cash decreases (a credit) and Prepaid Rent increases (a debit). Transaction 13 represents the subsequent expiration of one-third of the asset as an expense. 13. Transaction: Analysis:

Journal Entry:

Recognized expiration of rental services, $2,000. The asset Prepaid Rent decreases. Stockholders’ Equity, specifically Retained Earnings decreases because an expense account, Rent Expense, increases. Rent expense............................................ 2,000 Prepaid rent ......................................

2,000

Posting: Prepaid Rent (12)

6,000 (13)

Rent Expense 2,000

(13)

2,000

Be sure you understand that, in transaction 13, the effect of the $2,000 increase in Rent Expense is a decrease in retained earnings on the balance sheet.

ANALYZING, JOURNALIZING, AND POSTING THE BIWHEELS TRANSACTIONS

14. Transaction: Analysis:

Journal Entry:

105

Recognized depreciation, $100. The asset-reduction account Accumulated Depreciation, Store Equipment increases. Stockholders’ equity, specifically Retained Earnings, decreases because the expense account, Depreciation Expense, increases. Depreciation expense ...................................... 100 Accumulated depreciation, 100 store equipment....................................

Posting: Accumulated Depreciation, Store Equipment (14) 100

(14)

Depreciation Expense 100

In transaction 14, we open a new account, Accumulated Depreciation, Store Equipment. As the name implies, accumulated depreciation (sometimes called allowance for depreciation) is the cumulative sum of all depreciation recognized since the date of acquisition of an asset. It is a contra account—a separate but related account that offsets or is a deduction from a companion account. A contra account has two distinguishing features: (1) It always has a companion account, and (2) it has a balance on the opposite side from the companion account. In our illustration, accumulated depreciation is a contra asset account because its companion account is an asset. We deduct the balance in the contra asset from the related asset account. Although the normal balance of the asset account is a debit, the normal balance of accumulated depreciation is a credit. The asset and contra asset accounts on January 31, 20X2, are as follows: Asset: Contra asset: Net asset:

Store equipment Accumulated depreciation, store equipment Book value

$14,000 (100) $13,900

The book value, also called net book value, carrying amount, or carrying value, is the balance of an account minus the balance of any associated contra accounts. In our example, the book value of Store Equipment is $13,900, the original acquisition cost ($14,000) less the contra account for accumulated depreciation ($100).

A Note on Accumulated Depreciation Why do published annual reports routinely provide information on both the original cost of assets and the accumulated depreciation? For Biwheels, why don’t we reduce Store Equipment directly by $100? Conceptually, we could. However, accountants have traditionally preserved the asset’s original cost in the asset account throughout its useful life. They can then readily refer to that account to learn the asset’s initial cost. Reports to management, government regulators, and tax authorities sometimes require such information. Moreover, the original $14,000 cost is the height of accuracy—it is a reliable, objective number. In contrast, the balance in Accumulated Depreciation is an estimate, the result of a calculation, the accuracy of which depends heavily on the accountant’s less reliable prediction of an asset’s useful life. Recall that we calculated the monthly depreciation of $100 by dividing the $14,000 cost by an assumed useful life of 140 months. We do not know how long an asset will be useful. In calculating depreciation, we make estimates that are imperfect, but there is no better way to allocate the cost of the equipment over the periods that it benefits. Investors also find it useful to know the assets’ original costs. They can estimate the age of the assets by dividing the balance in Accumulated Depreciation by the original cost of the assets. For example, recently Delta Air Lines had accumulated depreciation of $4,820 million on property and equipment of $25,135 million, making its property and equipment about 19% depreciated. Five years ago Delta’s assets were 41% depreciated, so Delta has been replacing assets faster than it has been depreciating them. We can compare this with American Airlines, which has accumulated depreciation of $10,400 million on an original cost of $22,628 million. Therefore, its assets are ($10,400 ÷ $22,628) = 46% depreciated.

accumulated depreciation (allowance for depreciation) The cumulative sum of all depreciation recognized since the date of acquisition of an asset.

contra account A separate but related account that offsets or is a deduction from a companion account. An example is accumulated depreciation.

contra asset A contra account whose companion account is an asset. A contra asset account has a credit balance. We deduct the balance in the contra asset from an asset account.

book value (net book value, carrying amount, carrying value) The balance of an account shown on the books minus the value of any associated contra accounts. For example, the book value of equipment is its acquisition cost minus accumulated depreciation.

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CHAPTER 3 • RECORDING TRANSACTIONS

Summary Problem for Your Review PROBLEM An annual report of Kobe Steel, Ltd., one of the world’s largest producers of iron and steel, showed the following (Japanese yen in billions): Plant and equipment, at cost Accumulated depreciation

¥2,987 2,019

1. Open T-accounts for (a) Plant and Equipment, at cost, (b) Accumulated Depreciation, and (c) Depreciation Expense. Enter the balances in the Plant and Equipment and Accumulated Depreciation T-accounts. 2. Assume that during the ensuing year Kobe Steel purchased additional plant and equipment for cash of ¥97 billion and incurred depreciation expense of ¥115 billion. Prepare the journal entries, and post to the T-accounts opened in question 1. 3. Show how Kobe Steel would present its plant and equipment accounts in its balance sheet after the journal entries in requirement 2.

SOLUTION 1 & 2. Amounts are in billions of Japanese yen. Plant and Equipment, at Cost Bal.

2,987

(a) Bal.

97 3,084 Accumulated Depreciation Bal.

2,019

(b)

115

Bal.

2,134

Depreciation Expense (b)

115

a. Plant and equipment, at cost Cash b. Depreciation expense Accumulated depreciation

97 97 115 115

3. The plant and equipment section would appear as follows: Plant and equipment, at cost Less: Accumulated depreciation Plant and equipment, net

¥3,084 2,134 ¥ 950

Biwheels’ Transactions in the Journal and Ledger Exhibit 3-4 shows the journal entries for Biwheels’ transactions 4 through 14 as analyzed in the previous section and as listed in the general journal. The posting reference (Post Ref.) column uses the account numbers from the Biwheels chart of accounts on page 97. These account numbers also appear on each account in the Biwheels general ledger. Exhibit 3-5 shows the Biwheels general ledger in T-account form.

BIWHEELS’ TRANSACTIONS IN THE JOURNAL AND LEDGER

EXHIBIT 3-4 Biwheels Company General Journal

Date

Entry No.

20X2

4

5

6

7

Accounts and Explanation

9

10a

10b

11

130 100

120,000

Merchandise inventory Accounts payable Acquired inventory on credit

130 203

10,000

Merchandise inventory Cash Accounts payable Acquired merchandise inventory for cash plus credit (This is an example of a compound journal entry whereby more than two accounts are affected by the same transaction)

130 100 203

30,000

Cash

100 170

1,000

Accounts payable Merchandise inventory Returned some inventory to supplier

203 130

800

Accounts payable Cash Payments to creditors

203 100

4,000

Accounts receivable Sales revenue Sales to customers on credit

120 500

160,000

Cost of goods sold Merchandise inventory To record the cost of inventory sold

600 130

100,000

Cash

100 120

5,000

Prepaid rent Cash Payment of rent in advance

140 100

6,000

Rent expense Prepaid rent Recognize expiration of rental service

601 140

2,000

Depreciation expense Accumulated depreciation, store equipment Recognize depreciation for January

602 170A

100

Accounts receivable Collections from debtors 12

13

14

Debit

Merchandise inventory Cash Acquired inventory for cash

Store equipment Sold store equipment to business neighbor 8

Post Ref.

Credit

120,000

10,000

10,000 20,000

1,000

800

4,000

160,000

100,000

5,000

6,000

2,000

100

Pause and trace each of the following journal entries to its posting in the ledger in Exhibit 3-5. Recall that the first three journal entries are in Exhibit 3-1 on page 98; the rest of them are in Exhibit 3-4. 1. 2. 3. 4. 5. 6.

Initial investment Loan from bank Acquired store equipment for cash Acquired merchandise inventory for cash Acquired merchandise inventory for credit Acquired merchandise inventory for cash plus credit

107

108

EXHIBIT 3-5 Biwheels Company General Ledger Assets

=

Liabilities + Stockholders' Equity

(Increases on left, decreases on right) Cash

Account No. 100

(1)

400,000 (3)

15,000

(2)

100,000 (4)

120,000

(7)

1,000 (6)

10,000

(11)

5,000 (9) (12)

1/31 Bal.

Note Payable (2)

202 100,000

Paid-in Capital (1)

300 400,000

4,000 6,000

351,000 Accounts Receivable

(10a)

(Decreases on left, increases on right)

160,000

(11)

120 5,000

Accounts Payable (8)

800 (5)

(9)

4,000 (6)

1/31 Bal. 155,000

1/31 Bal.

203 10,000

Retained Earnings 1/31 Bal.

400 57,900*

20,000 25,200

Expense and Revenue Accounts Merchandise Inventory (4)

120,000 (8)

(5)

10,000 (10b)

(6)

30,000

1/31 Bal.

59,200

(12) 1/31 Bal.

140

6,000 (13)

2,000

100,000

Sales Revenues (10a)

500 160,000

Rent Expense (13)

601

2,000

170 1,000

Depreciation Expense (14)

602

100

14,000

Accumulated Depreciation, Store Equipment (14)

(10b)

600

4,000 15,000 (7)

1/31 Bal.

800

Cost of Goods Sold

100,000

Prepaid Rent

Store Equipment (3)

130

170A 100

Note: An ending balance is shown on the side of the account with the larger total. *The details of the revenue and expense accounts appear in the income statement. Their net effect is then transferred to a single account, Retained Earnings, in the balance sheet. In this case, ($160,000 – $100,000 – $2,000 – $100) = $57,900.

PREPARING THE TRIAL BALANCE

7. 8. 9. 10a. 10b. 11. 12. 13. 14.

Sold store equipment for cash Returned merchandise inventory for credit Paid cash to creditor Sales on credit Cost of merchandise inventory sold Collected cash from debtors Paid rent in advance Recognized expiration of rental services Recognized depreciation

As you trace these items, ask yourself why they appear on the left or right side of each account. You might find it useful to state the relationships explicitly as follows: “The initial investment was a debit to Cash and a credit to Paid-in Capital. The posting shows an entry on the left-hand side of the Cash account, which increases the balance in this asset account. It also shows a right-hand side entry to the Paid-in Capital account, which increases the balance in this stockholders’ equity account.” Accountants may update the ledger account balances from time to time as desired. We will use double horizontal lines, as in Exhibit 3-5, to signify that we have updated these accounts. A single number labeled “balance” (or Bal.) immediately below the double lines summarizes all postings above the double lines. We use this balance as a starting point for computing the next updated balance. The accounts in Exhibit 3-5 that contain only one number do not have a double line. Why? If there is only one number in a given account, this number automatically serves as the ending balance. For example, the Note Payable entry of $100,000 also serves as the ending balance for the account.

Preparing the Trial Balance After posting journal entries to the ledger, accountants prepare a trial balance (see step 4 on p. 96). Recall that a trial balance is a list of all accounts with their respective balances. Accountants prepare it as a test or check—a trial, as the name says—before proceeding further. Thus, the purpose of the trial balance is twofold: (1) to help check on the accuracy of postings by proving whether the total debits equal the total credits, and (2) to establish a convenient summary of the balances in all accounts for the preparation of financial statements. We can prepare a trial balance at any time the account balances are up-to-date. For example, we might prepare a trial balance for Biwheels on January 3, 20X2, after the company’s first three transactions: Biwheels Company Trial Balance, January 3, 20X2, for the Period January 2–3, 20X2 Balance Account Number 100

Account Title Cash

170

Store equipment

202

Note payable

300

Paid-in capital Total

Debit

Credit

$485,000 15,000 $100,000 400,000 $500,000

$500,000

The more accounts a company has, the more detailed the trial balance becomes and the more essential it is for checking the clerical accuracy of the ledger postings. Although the trial balance assures the accountant that the debits and credits are equal, errors can still exist. For example, an accountant may misread a $10,000 cash receipt on account as a $1,000 receipt and record the erroneous amount in both the Cash and Accounts Receivable accounts. Both Cash and Accounts Receivable would be in error by offsetting amounts. The balance in Cash would be understated by $9,000 and the balance in Accounts Receivable would be overstated by $9,000. Or the accountant might record a $10,000 cash receipt on account as a credit to Sales Revenue instead of a credit reducing Accounts Receivable. Sales Revenue and Accounts Receivable would both be overstated by $10,000. Nevertheless, the trial balance would still show total debits equal to total credits.

 OBJECTIVE 4 Prepare and use a trial balance.

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EXHIBIT 3-6 Biwheels Company Trial Balance, January 31, 20X2, for the Period January 1 to January 31, 20X2

Debits Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment

Credits

$ 351,000 155,000 59,200 4,000 14,000

Accumulated depreciation, store equipment

$

Note payable

100

100,000

Accounts payable

25,200

Paid-in capital

400,000 0*

Retained earnings Sales revenue Cost of goods sold Rent expense Depreciation expense Total

160,000 100,000 2,000 100 $685,300

$685,300

*If a Retained Earnings balance existed at the start of the accounting period, it would appear here. However, in our example, Retained Earnings was zero at the start of the period.

Exhibit 3-6 presents the trial balance based on the general ledger shown in Exhibit 3-5. Accountants normally prepare the trial balance with the balance sheet accounts listed first, assets, then liabilities, and then stockholders’ equity, followed by the income statement accounts, revenues and expenses. Note that the Retained Earnings account listed in Exhibit 3-6, has no balance because it was zero at the beginning of the period in our example. All balance sheet accounts except Retained Earnings show their balances as of the date the trial balance is prepared. Retained Earnings shows the balance at the beginning of the period. Why? Because we have recorded the changes in Retained Earnings for the current period in separate revenue and expense accounts rather than directly into Retained Earnings, so Retained Earnings remains at its beginning balance. When accountants prepare formal balance sheets, they reduce the revenue and expense accounts to zero and add their net effect to the beginning balance in the Retained Earnings account to arrive at the correct ending balance in Retained Earnings.

 OBJECTIVE 5 Close revenue and expense accounts and update retained earnings.

close the books To transfer the balances in all revenue and expense accounts to retained earnings, which resets the revenue and expense accounts to zero so that they are ready to record the next period’s transactions.

closing entries Journal entries that transfer balances in the “temporary” stockholders’ equity accounts (revenue and expense accounts) to the “permanent” stockholders’ equity account, Retained Earnings.

Closing the Books and Deriving Financial Statements from the Trial Balance The trial balance is the springboard for the last step of the process, closing the books and preparing the balance sheet and the income statement, as shown in Exhibit 3-7. To close the books we transfer the balances in all revenue and expense accounts to Retained Earnings, which resets the revenue and expense accounts to zero so that they are ready to record the next period’s transactions. Note that the balance in the Retained Earnings account in the balance sheet in Exhibit 3-7 is $57,900, although the amount of retained earnings in the trial balance is $0. Why? Because, after closing the books, the January 31 balance sheet shows the ending balance in Retained Earnings—the beginning balance of zero plus net income during the period. In future periods when we prepare a trial balance, the beginning balance will be the ending balance of the previous period. The beginning balance as of February 1 will be $57,900. Let’s examine the process of closing the books. Accountants make closing entries to transfer balances in the “temporary” stockholders’ equity accounts (revenue and expense accounts) to the “permanent” stockholders’ equity account, Retained Earnings. They may do this in two steps. First they transfer the amounts in each revenue and expense account to an Income Summary account, which becomes the basis for preparing the income statement. In the second step they transfer the amount in the Income Summary account to the permanent Retained Earnings account. Alternatively, accountants may transfer the revenue and expense accounts directly into the Retained Earnings account, bypassing the need for an Income Summary account. As a

EXHIBIT 3-7 Biwheels Company Trial Balance, Balance Sheet, and Income Statement Biwheels Company Trial Balance, January 31, 20X2

Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment Accumulated depreciation, store equipment Note payable Accounts payable Paid-in capital Retained earnings Sales revenue Cost of goods sold Rent expense Depreciation expense Total

Biwheels Company Balance Sheet, January 31, 20X2 Debits $351,000 155,000 59,200 4,000 14,000

Credits

$ 100 100,000 25,200 400,000 0* 160,000 100,000 2,000 100 $685,300

Assets Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment Less: Accumulated depreciation Total assets

$351,000 155,000 59,200 4,000 14,000 100

13,900 $583,100

Liabilities and Stockholders' Liabilities Note payable Accounts payable Total liabilities Stockholders’ equity Paid-in capital $400,000 57,900 Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

Biwheels Company Income Statement, for the Month Ended January 31, 20X2 $685,300

Sales revenue

$160,000

Deduct expenses *If there were a beginning balance in Retained Earnings, this balance would be added to the $57,900 from the income statement to compute Retained Earnings on the balance sheet.

Cost of goods sold Rent Depreciation Total expenses Net income

$100,000 2,000 100 102,100 $ 57,900}

Equity $100,000 25,200 $125,200

457,900 $583,100

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EXHIBIT 3-8 Biwheels Company Closing the Accounts—Data are from Exhibit 3-7 Cost of Goods Sold Bal.

100,000 C2

100,000

0 Rent Expense Bal.

2,000 C2

Income Summary 2,000

0

C2

102,100 C1

C3

Sales Revenue 160,000

C1

160,000 Bal.

160,000

57,900

0 0

Depreciation Expense Bal.

100 C2

Retained Earnings 100

Bal.

0

0

C3

57,900

New bal.

57,900

Note: Beginning balances are as shown in the Trial Balance in Exhibit 3-7.

student new to accounting, we recommend the use of the two-step approach to the closing process, which we demonstrate in Exhibit 3-8. The process closes the revenue accounts in entry C1 and closes the expense accounts in entry C2, transferring the amounts in revenue and expense accounts to the Income Summary account. Then, as a final step, entry C3 transfers the total net income for the period from the Income Summary to Retained Earnings. Notice that we opened a new temporary account called Income Summary. We use it only momentarily to keep track of the process. You will never see an Income Summary account listed on a financial statement. We transfer the revenue and expense amounts into Income Summary and then immediately transfer the balance to Retained Earnings. Slight variations on this process occur in different companies, but the end result is always the same—revenue and expense account balances are reset to zero and the net income generated during the period increases retained earnings. The following analysis gives the journal entries for the closing entries shown in Exhibit 3-8: C1. Transaction: Clerical procedure of transferring the ending balances of revenue accounts to the Income Summary account. Analysis: The stockholders’ equity account Sales Revenue decreases to zero. The stockholders’ equity account Income Summary increases. Journal Entry: Sales revenue. . . . . . . . . . . . . . . . . . . . .

160,000

Income summary . . . . . . . . . . . . . . . .

160,000

C2. Transaction: Clerical procedure of transferring the ending balances of expense accounts to the Income Summary account. Analysis: The negative stockholders’ equity (expense) accounts Cost of Goods Sold, Rent Expense, and Depreciation Expense decrease to zero. The stockholders’ equity account Income Summary decreases. Journal Entry: Income summary. . . . . . . . . . . . . . . . . . .

102,100

Cost of goods sold. . . . . . . . . . . . . . .

100,000

Rent expense . . . . . . . . . . . . . . . . . .

2,000

Depreciation expense . . . . . . . . . . . .

100

C3. Transaction: Clerical procedure of transferring the ending balance of Income Summary account to the Retained Earnings account. Analysis: The stockholders’ equity account Income Summary decreases to zero. The stockholders’ equity account Retained Earnings increases. Journal Entry: Income summary. . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . .

57,900 57,900

PREPARING THE TRIAL BALANCE

Summary Problem for Your Review PROBLEM The balance sheet of Hassan Used Auto Company, on March 31, 20X1, follows: Assets Cash

$ 10,000

Liabilities and Owner’s Equity Accounts payable $

3,000

Accounts receivable

20,000

Notes payable

70,000

Automobile inventory

100,000

Hassan, capital

57,000

Total assets

$130,000

Total liabilities and owner’s equity

$130,000

The Hassan business is a proprietorship, thus the owner’s equity account used here is Hassan, Capital. Hassan rented operating space and equipment on a month-to-month basis. During April, the business had the following summarized transactions: a. Invested an additional $20,000 cash in the business b. Collected $10,000 on accounts receivable c. Paid $2,000 on accounts payable d. Sold autos for $120,000 cash e. Cost of autos sold was $70,000 f. Replenished inventory for $60,000 cash g. Paid rent expense in cash, $14,000 h. Paid utilities in cash, $1,000 i. Paid selling expense in cash, $30,000 j. Paid interest expense in cash, $1,000

Required 1. Open the following T-accounts in the general ledger: Cash; Accounts Receivable; Automobile Inventory; Accounts Payable; Notes Payable; Hassan, Capital; Sales; Cost of Goods Sold; Rent Expense; Utilities Expense; Selling Expense; and Interest Expense. Enter the March 31 balances in the appropriate accounts. 2. Journalize transactions a through j and post the entries to the ledger. Identify entries by transaction letter. 3. Prepare the trial balance at April 30, 20X1. 4. Prepare an income statement for April. Ignore income taxes. 5. Give the closing entries.

SOLUTION The solutions to requirements 1 through 5 are in Exhibits 3-9 through 3-12. Exhibit 3-9 shows the journal entries. Exhibit 3-10 includes the appropriate opening balances and shows the posting of all transactions to the general ledger. Exhibit 3-11 presents the trial balance and the income statement. The closing entries appear in Exhibit 3-12.

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EXHIBIT 3-9 Hassan Used Auto Company General Journal ENTRY a.

POST REF.*

DEBIT

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

ACCOUNTS AND EXPLANATION



20,000

Hassan, capital . . . . . . . . . . . . . . . . . . . .



CREDIT 20,000

Investment in business by Hassan b.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



Accounts receivable . . . . . . . . . . . . . . . . .



10,000 10,000

Collected cash on accounts c.

Accounts payable . . . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



2,000 2,000

Disbursed cash on accounts owed to others d.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .



Sales Revenue . . . . . . . . . . . . . . . . . . . .



120,000 120,000

Sales for cash e.

Cost of goods sold . . . . . . . . . . . . . . . . . . . . Automobile inventory



70,000 70,000



Cost of inventory that was sold to customers f.

Automobile inventory . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



60,000 60,000

Replenished inventory g.

Rent expense . . . . . . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



14,000 14,000

Paid April rent h.

Utilities expense . . . . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



1,000 1,000

Paid April utilities i.

Selling expense. . . . . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



30,000 30,000

Paid April selling expenses j.

Interest expense . . . . . . . . . . . . . . . . . . . . . .



Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . .



1,000 1,000

Paid April interest expense

*Ordinarily, account numbers are used to denote specific posting references. Otherwise, check marks are used to indicate that the entry has been posted to the general ledger.

EXHIBIT 3-10 Hassan Used Auto Company General Ledger Cash

Accounts Payable

Bal.*

10,000 (c)

2,000

(a)

20,000 (f)

60,000

(b)

10,000 (g)

14,000

(d)

120,000 (h)

1,000

160,000 (i)

30,000

(j)

1,000

(c)

Bal.

Bal.*

Bal.*

57,000

1,000

(a)

20,000

Bal.

77,000

70,000

Sales Revenue (d)

(e)

70,000

Rent Expense (g)

Accounts Receivable Bal.*

20,000 (b)

Bal.

10,000

120,000

Cost of Goods Sold

108,000 52,000

3,000

Notes Payable



Bal.

2,000 Bal.*

Hassan, Capital

14,000

Selling Expense 10,000

(i)

30,000

Interest Expense (j)

1,000

Utilities Expense Automobile Inventory Bal.*

100,000 (e)

(f)

60,000

Bal.

90,000

*

(h)

1,000

70,000

Balances denoted with an asterisk are as of March 31; balances without asterisks are as of April 30. A lone number in any account also serves as an ending balance. Subtotals are included in the Cash account. They are not an essential part of T-accounts. However, when an account contains many postings, subtotals ease the checking of arithmetic.



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EXHIBIT 3-11 Hassan Used Auto Company Trial Balance and Income Statement, for the Month Ended April 30, 20X1 Account Title

Hassan Used Auto Company

Balance Debit

Cash

Credit

$ 52,000

Accounts receivable

10,000

Automobile inventory

90,000

Accounts payable

Income Statement, for the Month Ended April 30, 20X1 Sales

$120,000

Deduct expenses Cost of goods sold $

1,000

Rent expense

$70,000 14,000

Notes payable

70,000

Utilities expense

1,000

Hassan, capital

77,000*

Selling expense

30,000

Sales revenue

120,000

Cost of goods sold

70,000

Rent expense

14,000

Utilities expense

1,000

Selling expense

30,000

Interest expense Total

Interest expense

1,000

Net income

116,000 $

4,000

1,000 $268,000

$268,000

*Beginning balance of $57,000 plus additional investment of $20,000.

EXHIBIT 3-12 Hassan Used Auto Company Closing Entries

C1.

Sales Revenue ........................................

C2.

C3.

Income summary.....................................

Correct erroneous journal entries and describe how errors affect accounts.

correcting entry A journal entry that cancels a previous erroneous entry and adds the correct amounts to the correct accounts.

120,000 116,000

Cost of goods sold.............................

70,000

Selling expense .................................

30,000

Utilities expense ................................

1,000

Rent expense ....................................

14,000

Interest expense................................

1,000

Income summary..................................... Retained earnings..............................

 OBJECT IVE 6

120,000

Income summary ...............................

4,000 4,000

Effects of Errors Now that we have completed all steps of the recording process, let’s consider what happens when journal entries have errors. Suppose a journal entry contains an error. How do we correct it? If we discover the error immediately, we can rewrite the entry or reenter the correct data. However, if we detect the error after posting to ledger accounts, we must make a correcting entry. Correcting entries cancel a previous erroneous entry and add the correct amounts to the correct accounts. We record the correcting entry in the general journal and post it to the general ledger exactly as we would a regular entry. However, the end result is that we have corrected the balances in the accounts to what they should have been originally. Because we use the balances to prepare the financial statements, they must be correct.

EFFECTS OF ERRORS

117

Consider the following examples: 1. A company erroneously debited a $500 repair expense to the Equipment account on December 27. We discover the error on December 31: 12/27

CORRECT ENTRY

Repair expense ........................

500

Cash.................................. 12/27

ERRONEOUS ENTRY

500

Equipment ...............................

500

Cash.................................. CORRECTING ENTRY

12/31

500

Repair expense ........................

500

Equipment..........................

500

The correcting entry shows a credit to Equipment to cancel or offset the erroneous debit to  Equipment. It also debits Repair Expense, recognizing the amount that should have been recorded on December 27. Notice that the credit to Cash was correct, and therefore we did not change it. 2. A $3,000 collection on account was erroneously credited to Sales Revenue on November 2. We discover the error on November 28: CORRECT ENTRY

11/2

Cash ....................................

ERRONEOUS ENTRY

11/2

Cash ....................................

CORRECTING ENTRY

11/28

Sales revenue .......................

3,000

Accounts receivable .........

3,000 3,000

Sales revenue .................

3,000 3,000

Accounts receivable .........

3,000

The debit to Sales Revenue in the correcting entry offsets the incorrect credit to Sales Revenue. The credit to Accounts Receivable in the correcting entry recognizes the collected amount where it belongs, as a decrease in Accounts Receivable. Essentially, the correcting entry moves the $3,000 credit from the Sales Revenue account to the Accounts Receivable account. The debit to Cash in the original entry is correct, and thus we do not change it.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Suppose that on May 27, 20X0, a manager reported to the accounting department a purchase of equipment for $10,000 cash. The accountant recorded this transaction in the company’s books. Subsequent review of the transaction revealed that the manager had been in error and that the $10,000 was for supplies that his department used up during May. Prepare a correcting entry. Would this situation raise any potential ethical issues? Explain.

Answer CORRECTING ENTRY

Supplies expense Equipment

10,000 10,000

If it had gone undetected, the “error” would have kept the $10,000 expense from reducing income. This overstatement of income might have had a benefit for the manager, perhaps helping him meet a profit target needed for a bonus. The accountant would have an ethical obligation to investigate this transaction to make sure it was truly an error and not an attempt to manipulate income.

Temporary Errors Undetected errors can affect a variety of accounts, including revenues and expenses for a given accounting period. Some errors are automatically corrected in the ordinary bookkeeping process in the next period. Such errors misstate net income in both periods, which could mislead users of the financial statements. However, by the end of the second period the errors cancel each other out, and they affect the balance sheet of only the first period, not the second. Consider a payment of $1,000 made in December 20X1 to cover rent for the month of January 20X2. Instead of recording it as Prepaid Rent, the accountant listed the payment as Rent Expense in December:

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CHAPTER 3 • RECORDING TRANSACTIONS

INCORRECT ENTRY

12/X1

Rent expense...............................

1,000

Cash .......................................

1,000

One month’s rent CORRECT ENTRIES

12/X1

Prepaid rent .................................

1,000

Cash .......................................

1,000

Payment for January 20X2’s rent 1/X2

Rent expense...............................

1,000

Prepaid rent ............................

1,000

Expiration of January 20X2’s rent

The effects of this recording error are (1) to overstate 20X1’s rent expense (which understates pretax income and retained earnings) by $1,000 and understate 20X1’s year-end assets by $1,000 (because the prepayment would not be listed as an asset), and (2) to understate 20X2’s rent expense (which overstates pretax income) by $1,000. These errors have no effect on 20X2’s ending assets or retained earnings balances. Why? Because, regardless of whether the accountant made the incorrect entry shown above or the correct entries shown above, by the end of January 20X2 the only asset effect is a $1,000 decrease in Cash. With regard to the balance in retained earnings, the total of the pretax incomes for the 2 years is the same with or without the error. The first year’s understatement of pretax income by $1,000 offsets the second year’s overstatement of $1,000. The retained earnings balance at the end of the second year is thus correct on a pretax basis.

Errors that Persist Errors that do not automatically correct themselves will keep subsequent balance sheets in error until an accountant makes specific correcting entries. For example, overlooking a depreciation expense of $2,000 in 20X0 would (1) overstate pretax income, assets, and retained earnings by $2,000 in 20X0, and (2) continue to overstate assets and retained earnings on successive balance sheets for the life of the fixed asset. However, observe that the error would not affect pretax income for years after 20X0 unless accountants commit the same error again.

Incomplete Records A company’s accounting records are not always perfect. Someone may steal, lose, or destroy records, forcing accountants to make journal and ledger entries and create financial statements with incomplete information. Luckily, T-accounts can help accountants discover unknown amounts. For example, suppose the proprietor of a local sports shop asks your help in calculating her sales for 20X1. She provides the following accurate but incomplete information: List of customers who owe money December 31, 20X0

$

December 31, 20X1

4,000 6,000

Cash receipts from customers during 20X1 appropriately credited to customer’s accounts

280,000

She further tells you that all sales were on credit, not cash. How can you use T-accounts to solve for the missing credit sales figure? There are two basic steps to follow: Step 1: Enter all known items into the relevant T-account. In this case, we are looking for credit sales, which accountants debit to Accounts Receivable. By substituting S for the unknown credit sales, we can construct the following T-account: Accounts Receivable Bal. 12/31/X0

4,000

Credit sales

S

Total debits

(4,000 + S)

Bal. 12/31/X1

6,000

Collections

280,000

Total credits

280,000

DATA PROCESSING AND ACCOUNTING SYSTEMS

119

Step 2: Solve for the unknown. Finding this solution is a simple algebraic exercise. We can use the debit and credit relationships we have just learned to solve our problem: Total debits - Total credits = Balance (4,000 + S) - 280,000 = 6,000 S = 6,000 + 280,000 - 4,000 S = 282,000 The analyses of missing data become more complicated if there are more entries in a particular account or if there is more than one unknown value. Nevertheless, the idea is to fill in the account with all known debits, credits, and balances, and then solve for the unknown.

Data Processing and Accounting Systems Data processing is a general term referring to the procedures used to record, analyze, store, and report on chosen activities. An accounting system is a data processing system. Today most accounting systems are computerized. Software packages are available in many sizes and types. Small companies might use QuickBooks, Sage 50 Accounting, NetSuite, or Microsoft Small Business Manager. Many large companies build their accounting systems around larger enterprise resource planning (ERP) systems. Two of the largest ERP companies are the German company SAP and its American rival Oracle. These systems are based on the structure of journal entries and ledger accounts used in this book. They take the drudgery out of bookkeeping, but they have not fundamentally changed the way companies keep their accounting records. Whether you enter transactions data into a book or into a computer, the transactions data in general ledgers and general journals remain the same. The main advantage of a computerized accounting program is that the computer can automatically carry out steps such as general-ledger postings and financial statement preparation. Computers affect more than the processing of data and preparation of reports. When you check out at a Walgreens drugstore or H&M clothing store, the cash register often does more than just record a sale. It may be linked to a computer that also records a decrease in inventory. It may activate an order to a supplier if the inventory level is low. If a sale is on credit, the computer may check your credit limit, update the company’s accounts receivable, and eventually prepare your monthly billing statement. Most importantly, the computer can automatically enter every transaction into the journal as it occurs, thereby reducing the amount of source-document paperwork and potential data entry errors. Automation has consistently decreased the cost of data processing. Consider American Express, a financial services company that has almost 88 million credit card holders and is the world’s largest credit issuer as measured by purchase volume. American Express recently reported annual purchase volume of $620 billion! Given the magnitude of sales, American Express would receive millions of separate sales slips daily if its system were manual. However, computers record most credit sales by reading the magnetic strips on credit cards. Grocery stores and other retail establishments get most payments by swiping a customer’s credit card through a scanner. Most gas stations have the card-reading equipment built into the gasoline pumps, even eliminating the need for sales clerks. Information about each credit sale is electronically submitted to a central computer, which prepares all billing documents and financial statements. Companies automatically record millions of transactions into their general journals without any paperwork or keyboard entry, producing huge savings in time and money while increasing accuracy. Computers also reduce the time it takes to close the books and prepare financial statements. IBM announced its financial results for the year ended December 31, 2011, in a Webcast at 4:30 PM ET on January 19, 2012. It took less than 3 weeks for a company with nearly $100 billion in sales to finalize its results. Computer-based systems have also allowed the SEC to require large companies to file 10-K reports within 60 days after year-end rather than the 90 days required until this decade. The most recent advance in data processing for financial reporting is the use of XBRL (eXtensible Business Reporting Language), an XML-based computer language that allows easy comparisons across companies. We describe this in the Business First box on page 120.

OBJECTIVE 7 Explain how computers have transformed the processing of accounting data.

data processing The procedures used to record, analyze, store, and report on chosen activities.

XBRL eXtensible Business Reporting Language, an XML-based computer language that allows easy comparisons across companies.

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BUSINESS FIRST D ATA P R O C E S S I N G U S I N G X B R L The Internet has created new opportunities for companies to report and exchange financial information. The first step was putting financial statements on the Web in PDF format. This conveyed the information quickly and easily, but it did not allow analysis of the data. Some companies then made the statements available in Excel format. This allowed analysis between years and between different statements for the same company, but it did not allow intercompany analyses. To address this issue, an original group of 12 organizations (including the AICPA, Deloitte & Touche LLP, Ernst & Young LLP, Great Plains Software, KPMG LLP, Microsoft Corporation, and PricewaterhouseCoopers LLP) formed XBRL International in August 1999 to create a common XML-based language for the reporting of business information. In just over 10 years XBRL has become widely used throughout the world. You can view the current status of XBRL on the Web at www.xbrl.org. One reason for the growth in usage of XBRL (eXtensible Business Reporting Language) is the growing number of regulators, lenders, and other consumers of financial information demanding information in this format. Since 2011 the SEC has required all companies to submit their financial statements in XBRL format. When creating an XBRL submission for the SEC, companies choose electronic data tags from the U.S. GAAP taxonomy, which is an electronic description and classification system for financial statements, disclosures, and other reports. This data tagging system provides a unique electronically readable tag for each individual disclosure item in financial statements, footnotes, and financial statement schedules. These electronic tags enable computers to read the financial information. The SEC makes the following comparison on their Web site: “XBRL allows computers to read financial information and use it in analytical tools, much like bar codes applied to merchandise are used for computerized inventory controls.” Once data are coded in XBRL, different types of reports using various subsets of the data can be produced with minimal effort. To facilitate international application of XBRL, the IASB and XBRL International have also developed an XBRL taxonomy that models the primary financial statements that a commercial and industrial entity may use to report under IFRS. What are the benefits of XBRL? Users can download an XBRL document using one of many available XBRL reader software products. These software products

can generate reports suitable for the individual user’s needs. A recent report issued by EDGAR Online discloses how accountants, institutional investors, and attorneys are using the data to analyze company financial statements. Of the survey respondents, 74% indicated that they are using the data to perform industry or market financial analysis, 51% for benchmarking competitors or comparable companies, 40% for analyzing equity investment decisions, and 30% for identifying or evaluating mergers, acquisitions, and partnerships. Another argument for the push to XBRL was that it would not only help investors compare and contrast companies, but that it would improve internal company reporting. For example, a company using XBRL should be able to quickly, efficiently, and cheaply assemble and integrate data from divisions that use different accounting systems, create a variety of reports with minimal effort, and expedite tax and other regulatory filings. While all of this and more is possible with XBRL, some company CFOs question the benefit to the company. Mathew Watson, senior director, external reporting and corporate accountant at Best Buy noted: “The argument that reporting language can be leveraged internally? We don’t think that’s the case. We think our internal mechanisms work well. XBRL is just a compliance need. The internal use of XBRL is not even on our horizon.” Proponents of XBRL also claim that it can improve the quality of financial reporting by making monitoring of reporting easier. Prior to the XBRL requirement, the SEC was able to review only a small percentage of the filings made by publicly traded companies. If companies submit financial statements in XBRL format, the SEC can use analytic software to electronically screen nearly all filings. Intra-industry and cross-industry analyses may reveal anomalies that lead to further investigation of the financial reports. Can this eliminate fraudulent reporting? No, but it might more quickly and easily identify problems, making accountants and executives think twice before deciding to manipulate their financial numbers. Sources: XBRL International Web site (www.xbrl.org); E. Z. Taylor, and A. C. Dzuranin, “Interactive Financial Reporting: An Introduction to eXtensible Business Reporting Language (XBRL),” Issues in Accounting Education, Vol. 25, No. 1, 2010, pp. 71–83; M. Cohn, “Acc’ts Mining XBRL Data,” Webcpa, August 1, 2011; D. Rosenbaum, “XBRL: What’s It Good For?” CFO.com, July 28, 2011; Securities and Exchange Commission, Summary of XBRL Information for Phase 3 Filers (modified May 10, 2011) on SEC Web site (www.sec.gov/spotlight/xbrl/xbrlsummaryinfophase3-051011.shtml); “IASC Foundation and XBRL PFS Taxonomy Release,” International Accounting Standards Board Press Release, 27 November 2002; N. Hannon, “Accounting Scandals: Can XBRL Help?” Strategic Finance, August 2002, pp. 61–62.

ACCOUNTING VOCABULARY

Highlights to Remember

1

Use double-entry accounting. Double-entry accounting refers to the fact that every transaction affects at least two accounts. For example, we not only keep track of an increase in cash, but we also keep track of whether that increase arose from making a sale or borrowing money. To help us understand the double-entry accounting system, we use a simplified version of general ledger accounts called T-accounts. Accountants at all levels use T-accounts to help think through complex transactions. Accountants use the terms debit and credit repeatedly. Remember that debit means “left side” and credit means “right side.” Describe the five steps in the recording process. There are 5 steps in the process that leads to the preparation of financial statements: (1) create source documents, (2) record transactions in a general journal, (3) post journal entries to the general ledger, (4) prepare a trial balance, and (5) close the books and prepare financial statements. Analyze and journalize transactions and post journal entries to the ledgers. The general journal provides a chronological record of transactions. For each transaction it includes the date and an identification number for the transaction, the accounts affected, the amounts of the debits and credits, the identifying number used to post each account to the general ledger, and an explanation of the transaction. After we initially record transactions as journal entries in the general journal, we post the elements of each transaction to the proper accounts in the general ledger. The general ledger accounts accumulate all the transactions affecting the account over time. We determine the balance in a specific general ledger account by adding all debits and all credits and subtracting the totals. Prepare and use a trial balance. Trial balances are internal reports that list each account in the general ledger together with the balance in that account as of the trial balance date. Accountants use trial balances for detecting errors in the accounts and in preparing financial statements. Trial balances that fail to balance are the result of errors in journalizing or posting. The good news is that the out-of-balance condition lets you know that an error has been made. Close revenue and expense accounts and update retained earnings. At the end of each accounting period, accountants “close” the temporary revenue and expense accounts. This involves resetting them to zero by transferring their balances for the period into an Income Summary account, which we in turn transfer to the Retained Earnings account. Correct erroneous journal entries and describe how errors affect accounts. Despite precautions, errors sometimes occur in accounting entries. Accountants correct such errors when discovered by making correcting entries that reverse the errors and adjust account balances so they equal the amounts that would have existed if the correct entries had been made. Explain how computers have transformed the processing of accounting data. Computers are fast and efficient and enable the performance of repetitive tasks with complete accuracy, reducing human effort and errors. Many software packages are available to aid in the processing of accounting transactions. Computers perform tasks from initial recording of a sale, to journalizing and posting, to creation of trial balances and financial statements, and finally to sending financial information to interested parties over the Web.

2 3

4 5 6 7

Accounting Vocabulary accumulated depreciation, p. 105 allowance for depreciation, p. 105 balance, p. 92 book of original entry, p. 96 book value, p. 105 carrying amount, p. 105

carrying value, p. 105 charge, p. 95 chart of accounts, p. 96 close the books, p. 110 closing entries, p. 110 compound entry, p. 100 contra account, p. 105 contra asset, p. 105

correcting entry, p. 116 credit, p. 95 cross-referencing, p. 99 data processing, p. 119 debit, p. 95 double-entry system, p. 92 general journal, p. 92 general ledger, p. 92

121

122

CHAPTER 3 • RECORDING TRANSACTIONS

journal entry, p. 97 journalizing, p. 97 ledger account, p. 92 net book value, p. 105

posting, p. 98 simple entry, p. 100 source documents, p. 96 T-accounts, p. 92

trial balance, p. 96 XBRL, p. 119

Assignment Material Questions 3-1 “Double entry means that amounts are shown in both the general journal and general ledger.” Do you agree? Explain. 3-2 “Increases in cash and accounts payable are shown on the right side of their respective accounts.” Do you agree? Explain. 3-3 “Debit and credit are used as verbs, adjectives, or nouns.” Give examples of how credit may be used in these three meanings. 3-4 Name three source documents for transactions. 3-5 “The general ledger is the major book of original entry because it is more essential than the general journal.” Do you agree? Explain. 3-6 “Revenue and expense accounts are really little stockholders’ equity accounts.” Explain.

3-7 Give two synonyms for book value. 3-8 “Accumulated depreciation is the total depreciation expense for the year.” Do you agree? Explain. 3-9 What is a trial balance and what purpose does it serve? 3-10 “If debits equal credits in a trial balance, you can be assured that no errors were made.” Do you agree? Explain. 3-11 What is the role of the Income Summary account when closing the books? 3-12 “In double-entry accounting, errors are not a problem because they are self-correcting.” Do you agree? Explain. 3-13 Are all data processing systems for accounting computerized? Explain.

Critical Thinking Questions  OBJECTIVE 2

 OBJECTIVE 3

 OBJECTIVE 3

 OBJECTIVE 7

3-14 The Chart of Accounts You have just joined the accounting staff of a fast-food company. You are surprised that this company has a chart of accounts with twice as many accounts as the fast-food company you previously worked for, even though the current client’s sales are one-half as large. You are tempted to write a very critical memo to your manager about this issue. You have asked a more experienced friend for advice. What might this friend ask about these clients? 3-15 The Relation of Expense and Retained Earnings Accounts A fellow student asked you the following: “I understand that a debit increases an expense account. I also understand that a debit decreases retained earnings. But if an expense account is a part of retained earnings (a ‘little’ stockholders’ equity account), how can a debit entry have a different effect on retained earnings than it does on an expense account?” Provide an explanation to the student. 3-16 Reconstructing Transactions Your supervisor in the accounting department has asked you to trace transactions from the general journal to the general ledger. You are partway into the task when you find at the top of one page in the general journal that a coffee spill has obliterated part of a transaction. You can see that the debit portion of the transaction was for $1,000 to rent expense, but the credit portion is illegible. How might you go about recreating what happened? 3-17 Manual Versus Computerized Accounting Systems As a new auditor, you have just been assigned to the audit of a company with a highly computerized accounting system. How would you expect an audit of such a system to differ from the audit of a small company whose records are maintained manually?

ASSIGNMENT MATERIAL

Exercises 3-18 Debits and Credits For each of the following accounts, indicate whether it normally possesses a debit or a credit balance (use dr. or cr.): 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

Sales Supplies Expense Accounts Receivable Accounts Payable Supplies Inventory Retained Earnings Dividends Payable Depreciation Expense Paid-in Capital Subscription Revenue Equipment Accumulated Depreciation Cost of Goods Sold Prepaid Rent

3-19 Debits and Credits Indicate for each of the following transactions whether an accountant will debit or credit the account named in parentheses (use dr. or cr.): 1. 2. 3. 4. 5. 6. 7.

 OBJECTIVE 1

Sold merchandise (Merchandise Inventory), $1,500 Bought merchandise on account (Merchandise Inventory), $4,000 Paid Napoli Associates $3,000 owed them (Accounts Payable) Received cash from customers on accounts due (Accounts Receivable), $2,000 Bought merchandise on open account (Accounts Payable), $5,000 Borrowed money from a bank (Notes Payable), $10,000 Sold merchandise (Cost of Goods Sold) $1,500

3-20 Debits and Credits For the following transactions, indicate whether the accountant for Jacksonville Company should debit or credit the account in parentheses (use dr. or cr.): 1. 2. 3. 4. 5. 6.

 OBJECTIVE 1

 OBJECTIVE 1

Jacksonville sold merchandise on credit (Accounts Receivable). Jacksonville received interest on an investment (Interest Revenue). Jacksonville declared dividends and paid them in cash (Retained Earnings). Jacksonville paid wages to employees (Wages Expense). Jacksonville sold merchandise for cash (Sales Revenue). Jacksonville acquired a 4-year fire insurance policy (Prepaid Expenses).

3-21 True or False Use T or F to indicate whether each of the following statements is true or false: 1. Repayments of bank loans should be charged to Notes Payable and credited to Cash. 2. Cash payments of accounts payable should be recorded by a debit to Cash and a credit to Accounts Payable. 3. Inventory purchases on account should be credited to Accounts Payable and debited to an expense account. 4. All credit entries are recorded on the right side of accounts and represent decreases in the account balances. 5. Cash collections of accounts receivable should be debited to Cash and credited to Accounts Receivable. 6. Credit purchases of equipment should be debited to Equipment and charged to Accounts Payable.

 OBJECTIVE 1

123

124

CHAPTER 3 • RECORDING TRANSACTIONS

7. 8. 9. 10.

In general, entries on the right side of asset accounts represent decreases in the account balances. Increases in asset and expense accounts should be recorded on the left side of the accounts. Increases in retained earnings are recorded as credits. Both decreases in assets and decreases in liabilities are recorded on the debit sides of accounts. 11. Asset debits should be on the right and liability debits should be on the left. 12. In some cases, increases in account balances are recorded on the right sides of accounts.

 OBJECTIVE 2

 OBJECTIVE 3

3-22 5-Step Recording Process Suppose you buy a $125 pair of shoes for cash from Nike on November 12, 20X0. The shoes cost Nike $80. Follow the accounting for your purchase through the five steps that lead from recording your purchase to its inclusion in Nike’s financial statements. List each step and what happens to the record of your purchase in the step. 3-23 Matching Transaction Accounts Listed here are a series of accounts that are numbered for identification. Accompanying this problem are columns in which you are to write the identification numbers of the accounts affected by the transactions described. You may use the same account in several answers. For each transaction, indicate which account or accounts are to be debited and which are to be credited. The first transaction is completed for you. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Cash Accounts Receivable Inventory Equipment Accumulated Depreciation, Equipment Prepaid Insurance Accounts Payable Notes Payable Paid-in Capital Retained Earnings Sales Revenue Cost of Goods Sold Operating Expense Debit

Credit

(a)

Purchased new equipment for cash plus a short-term note

4

1, 8

(b)

Paid some old trade bills with cash

__________

__________

(c)

Made sales on credit: Inventory is accounted for as each sale is made

__________

__________

(d)

Paid cash for salaries and wages for work done during the current fiscal period

__________

__________

(e)

Collected cash from customers on account

__________

__________

(f)

Bought regular merchandise on credit

__________

__________

(g)

Purchased 3-year insurance policy on credit

__________

__________

(h)

Paid cash for inventory that arrived today

__________

__________

(i)

Paid off note owed to bank

__________

__________

(j)

To secure additional funds, 400 new shares of common stock were sold for cash

__________

__________

Recorded the entry for depreciation on equipment for the current fiscal period

__________

__________

Paid cash for ad in today’s Wall Street Journal Some insurance premiums have expired

__________ __________

__________ __________

(k) (l) (m)

ASSIGNMENT MATERIAL

3-24 Prepaid Expenses Continental AG is a large German supplier of auto parts. Assume that Continental had €62.4 million of prepaid expenses on January 1, 2012. (€ stands for euro, the European currency.) This item mainly consists of prepayments of rent, leasing fees, interest, and insurance premiums. Assume all these prepayments were for services that Continental used during 2012 and that Continental spent €164 million in cash during 2012 for rent, leasing fees, and interest, of which €38 million was a prepayment of expenses for 2013.

 OBJECTIVE 3

1. Prepare a journal entry recognizing the use of the €62.4 million of prepaid expenses during 2012. 2. Prepare a compound journal entry for the cash payment of €164 million for rent, leasing fees, interest, and insurance premiums during 2012, with the proper amounts going to expense and prepaid expenses. 3-25 Journalizing and Posting (Alternate is 3-26.) Prepare journal entries and post to T-accounts the following transactions of Toronto Building Supplies: a. b. c. d. e.

Cash sales, $10,000; items sold cost $4,500 Collections on accounts, $8,500 Paid cash for wages, $3,500 Acquired inventory on open account, $5,000 Paid cash for janitorial services, $550

3-26 Journalizing and Posting (Alternate is 3-25.) Prepare journal entries and post to T-accounts the following transactions of Washington Real Estate Company: a. b. c. d. e.

 OBJECTIVE 3

 OBJECTIVE 3

Acquired office supplies of $900 on open account. Use a Supplies Inventory account. Sold a house and collected an $9,000 commission on the sale. Use a Commissions Revenue account. Paid cash of $750 to a local newspaper for current advertisements. Paid $500 for a previous credit purchase of office supplies. Recorded office supplies used of $300.

3-27 Reconstruct Journal Entries (Alternate is 3-28.) Reconstruct the journal entries (with explanations) that resulted in the postings to the following T-accounts of Four Seasons Heating Contractors: Cash (a)

70,000

Equipment

(b)

1,500

(c)

5,000

(c)

Accounts Receivable (d)

87,000

1,500

(d)

(c)

(e)

87,000

Note Payable

Supplies Inventory (b)

Revenue from Fees

15,000

10,000

Paid-in Capital

400

(a)

Supplies Expense 70,000

(e)

400

3-28 Reconstruct Journal Entries (Alternate is 3-27.) Reconstruct the journal entries (omit explanations) that resulted in the postings to the following T-accounts of a small fruit wholesaler: Cash (a)

50,000

(e)

Accounts Payable 18,000

(e)

18,000

(b)

80,000

Paid-in Capital (a)

50,000

Accounts Receivable (c)

110,000 Inventory

(b)

80,000

(d)

Cost of Goods Sold 68,000

(d)

68,000

Sales Revenue (c)

110,000

 OBJECTIVE 3

125

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CHAPTER 3 • RECORDING TRANSACTIONS

 OBJECT IVES 3, 4

3-29 Trial Balance Gamma Company had total assets (cash and inventories) of $50,000, total liabilities of $30,000, and stockholders’ equity of $20,000 at the beginning of 20X0. During the year Gamma purchased inventory for $65,000 cash and sold all of that inventory for $100,000 cash. Total expenses other than cost of goods sold were $20,000, all paid in cash. 1. Enter the beginning balances into three T-accounts: Total Assets, Total Liabilities, and Stockholders’ Equity. 2. Prepare journal entries for the transactions in 20X0. Post the inventory purchases, sales revenue, and expenses to the three T-accounts, opening new accounts for revenues and expenses as needed. 3. Prepare a trial balance at the end of 20X0.

 OBJECT IVE 5

3-30 Closing Accounts Use the information for Gamma Company in Exercise 3-29. Prepare closing entries to transfer all temporary accounts to an Income Summary account, and then close the Income Summary account to Stockholders’ Equity. Note that Stockholders’ Equity includes both paid-in capital and retained earnings; there is no way to separate the two with the information given.

 OBJECTIVE 5

3-31 Closing Accounts and Preparing Financial Statements Bonfiglio Company imports art and artifacts from Italy and Spain and sells them in its Bonfiglio Gallery in London. At the end of 20X2 Bonfiglio had the following trial balance: Cash

£ 44,000

Accounts receivable

23,000

Inventories

75,000

Fixed assets, net

121,000

Accounts payable

£ 36,000

Paid-in capital

90,000

Retained earnings, Jan. 1, 20X2

92,000

Revenue

345,000

Cost of sales

165,000

Operating expenses

135,000

Totals

£563,000

£563,000

1. Prepare closing journal entries for Bonfiglio Company. 2. Prepare an income statement for 20X2 and a balance sheet for December 31, 20X2.

 OBJECT IVE 6

3-32 Effects of Errors The bookkeeper of Rollins Legal Services included the cost of a new computer, purchased on December 30 for $5,000 and to be paid for in cash in January, as an operating expense instead of an addition to the proper asset account. What was the effect of this error (“no effect,” “overstated,” or “understated” —use symbols N, O, or U, respectively) on the following? 1. Total assets as of December 31 2. Total liabilities as of December 31 3. Operating expenses for the year ended December 31 4. Profit from operations for the year 5. Retained earnings as of December 31 after the books are closed

 OBJECTIVE 6

3-33 Effects of Errors Analyze the effect of the following errors on the net profit figures of Yokahama Trading Company (YTC) for 20X0 and 20X1. Choose one of three answers: understated (U), overstated (O), or no effect (N). Problem 1 has been answered as an illustration. 1. Example: Failure to adjust at end of 20X0 for prepaid rent that had expired during December 20X0. YTC charged the remaining prepaid rent in 20X1. Answer: 20X0: O; 20X1: U. (Explanation: In 20X0, expenses would be understated and profits overstated. This error would carry forward so expenses in 20X1 would be overstated and profits understated.) 2. YTC omitted recording depreciation on Office Machines in 20X0 only. Correct depreciation was taken in 20X1.

ASSIGNMENT MATERIAL

127

3. During 20X1, YTC purchased ¥40,000 of office supplies and debited Office Supplies, an asset account. At the end of 20X1, ¥10,000 worth of office supplies were left. No entry had recognized the use of ¥30,000 of office supplies during 20X1. 4. Machinery, with a cost of ¥500,000, bought in 20X0, was not entered in the books until paid for in 20X1. Ignore depreciation; answer in terms of the specific error described. 5. YTC debited 3 months’ rent, paid in advance in December 20X0, for the first quarter of 20X1, directly to Rent Expense in 20X0. No prepaid rent was on the books at the end of 20X1.

Problems 3-34 Account Numbers, Journal, Ledger, and Trial Balance Journalize and post the entries required by the following transactions for Francisco Furniture Repair Company. Prepare a trial balance as of April 30, 20X0, for the period April 1 to April 30, 20X0. Ignore interest. Use dates, posting references, and the following chart of accounts. As you identify the need for specific expense accounts, assign each expense account its own account number. Cash

100

Note payable

130

Accounts receivable

101

Paid-in capital

140

Equipment

111

Retained earnings

150

Sales revenue

200

Expenses

300, 301, etc.

Accumulated depreciation, equipment

111A

Accounts payable

 OBJECTIVES 3, 4

120

• April 1, 20X0.The Francisco Furniture Repair Company was formed with $100,000 cash on the issuance of common stock. • April 2. Francisco acquired equipment for $70,000. Francisco made a cash down payment of $20,000. In addition, Francisco signed a note for $50,000. • April 3. Sales on credit to repair furniture at a local hotel, $3,500. • April 3. Supplies acquired (and used) on open account, $200. • April 3. Wages paid in cash, $700. • April 30. Depreciation expense for April, $2,000.

 OBJECTIVES 3, 4

3-35 Account Numbers, T-Accounts, and Transaction Analysis Consider the following: Vancouver Computing Trial Balance, December 31, 20X0 ($ in thousands) Balance Account Number

Account Titles

Debit

10

Cash

20

Accounts receivable

115

21

Note receivable

100

30

Inventory

130

40

Prepaid insurance

70

Equipment

70A

Accumulated depreciation, equipment

80

Accounts payable

$

Credit

60

12 120 $

30 140

100

Paid-in capital

65

110

Retained earnings

182

130

Sales revenue

950

150

Cost of goods sold

550

160

Wages expense

200

170

Miscellaneous expense

80 $1,367

$1,367

128

CHAPTER 3 • RECORDING TRANSACTIONS

The following information had not been considered before preparing the trial balance: a. The $100,000 note receivable was signed by a major customer. It is a 3-month note dated November 1, 20X0. Interest earned during November and December was collected in cash at 4 pm on December 31. The interest rate is 6% per year. b. The Prepaid Insurance account reflects a 1-year fire insurance policy acquired for $12,000 cash on September 1, 20X0. c. Depreciation for 20X0 was $18,000. d. Vancouver Computing paid wages of $12,000 in cash at 5 pm on December 31. Required 1. Enter the December 31 balances in T-accounts in a general ledger. Number the accounts. Allow room for additional T-accounts. 2. Prepare the journal entries prompted by the additional information. Show amounts in thousands. 3. Post the journal entries to the ledger. Key your postings. Create logical new account numbers as necessary. 4. Prepare a new trial balance, December 31, 20X0.

 OBJECT IVE 4

3-36 Trial Balance Errors Consider the following trial balance ($ in thousands): Powell Paint Store Trial Balance, Year Ended December 31, 20X0 Cash Equipment Accumulated depreciation, equipment Accounts payable Accounts receivable Prepaid insurance Prepaid rent Inventory Paid-in capital Retained earnings Cost of goods sold Wages expense Miscellaneous expenses Advertising expense Sales Note payable

$ 22 33 15 42 14 1 $

3

129 17 10 500 100 80 30 788 40 $976

$848

List and describe all the errors in the preceding trial balance. Be specific. On the basis of the available data, prepare a corrected trial balance.

 OBJECT IVES 3, 4

3-37 Journal, Ledger, and Trial Balance (Alternates are 3-39 through 3-44.) The balance sheet accounts of Detroit Machinery, Inc., had the following balances on October 31, 20X0:

ASSIGNMENT MATERIAL

Cash Accounts receivable Inventory Prepaid rent Accounts payable Paid-in capital Retained earnings

$ 41,000 90,000 70,000 2,000 $ 27,000 160,000 $203,000

16,000 $203,000

Following is a summary of the transactions that occurred during November: a. b. c. d. e. f. g.

Collections of accounts receivable, $75,000. Payments of accounts payable, $14,000. Acquisitions of inventory on open account, $80,000. Merchandise carried in inventory at a cost of $70,000 was sold on open account for $96,000. Recognition of rent expense for November, $1,000. Wages paid in cash for November, $8,000. Cash dividends declared and disbursed to stockholders on November 29, $10,000.

Required 1. Prepare journal entries. 2. Enter beginning balances in T-accounts. Post the journal entries to T-accounts. Use the transaction letters to key your postings. 3. Prepare a trial balance for the month ending November 30, 20X0. 4. Explain why accounts payable increased by so much during November. 3-38 Financial Statements Refer to problem 3-37. Prepare a balance sheet as of November 30, 20X0, and an income statement for the month of November. Prepare the retained earnings column of a statement of stockholders’ equity. Prepare the income statement first. 3-39 Journal, Ledger, and Trial Balance (Alternates are 3-37 and 3-40 through 3-44.) The balance sheet accounts of Red Lake Appliance Company had the following balances on December 31, 20X1: Balance Account Title Cash Accounts receivable Merchandise inventory

Debit

Credit

$ 43,000 29,000 120,000

Accounts payable

$ 35,000

Notes payable

83,000

Paid-in capital

43,000

Retained earnings

31,000

Total

$192,000

$192,000

 OBJECTIVES 4, 5

 OBJECTIVES 3, 4

129

130

CHAPTER 3 • RECORDING TRANSACTIONS

Operating space and equipment are rented on a month-to-month basis. A summary of January 20X2 transactions follows: a. b. c. d. e. f. g. h.

Collected $24,000 on accounts receivable. Sold appliances for $60,000 cash and $45,000 on open account. Cost of appliances sold was $56,000. Paid $25,000 on accounts payable. Replenished inventory for $64,000 on open account. Paid selling expense in cash, $33,000. Paid rent expense in cash, $7,000. Paid interest expense in cash, $2,000.

Required 1. Open the appropriate T-accounts in the general ledger. In addition to the seven accounts listed in the trial balance of December 31, open accounts for Sales, Cost of Goods Sold, Selling Expense, Rent Expense, and Interest Expense. Enter the December 31 balances in the accounts. 2. Journalize transactions a through h. Post the entries to the ledger, keying by transaction letter. 3. Prepare a trial balance for the month ended January 31, 20X2.

 OBJECTIVES 3, 4, 5

3-40 Journal, Ledger, and Trial Balance (Alternates are 3-37, 3-39, and 3-41 through 3-44.) Robert Kapela owned and managed a franchise of Ithaca Espresso, Incorporated. The company’s balance sheet accounts had the following balances on September 1, 20X0, the beginning of a fiscal year: Ithaca Espresso Balance Sheet Accounts, September 1, 20X0 Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment

$ 13,000 5,200 77,800 4,000 21,000

Accumulated depreciation, store equipment

$

6,150

Accounts payable

40,000

Paid-in capital

30,000

Retained earnings

44,850 $121,000

$121,000

Summarized transactions for September were as follows: a. b. c. d. e. f. g. h. i. j.

Acquisitions of merchandise inventory on account, $41,000. Sales for cash, $74,250. Payments to creditors, $29,000. Sales on account, $3,000. Advertising in newspapers, paid in cash, $3,000. Cost of goods sold, $45,000. Collections on account, $6,000. Miscellaneous expenses paid in cash, $8,000. Wages paid in cash, $9,000. Entry for rent expense. (Rent was paid quarterly in advance, $6,000 per quarter. Payments were due on February 1, May 1, August 1, and November 1.) k. Depreciation of store equipment, $250.

ASSIGNMENT MATERIAL

131

Required 1. Enter the September 1 balances in T-accounts in a general ledger. 2. Prepare journal entries for each transaction. 3. Post the journal entries to the ledger. Key your postings by transaction letter. 4. Prepare an income statement for September and a balance sheet as of September 30, 20X0. 3-41 Journalizing, Posting, and Trial Balance (Alternates are 3-37, 3-39, 3-40, and 3-42 through 3-44.) Tsugawa Nursery, a retailer of garden plants and supplies, had the accompanying balance sheet accounts on December 31, 20X0: Assets Cash

$ 24,000

Accounts receivable

40,000

Merchandise inventory

131,000

Prepaid rent Store equipment Less: Accumulated depreciation Total

Liabilities and Stockholders’ Equity Accounts payable* $116,000 Paid-in capital

40,000

Retained earnings

79,000

4,000 $60,000 24,000

36,000 $235,000

Total

$235,000

*For merchandise only.

Following is a summary of aggregate transactions that occurred during 20X1: a. b. c. d. e. f. g.

h. i. j.

Purchases of merchandise inventory on open account, $550,000. Sales, all on credit, $810,000. Cost of merchandise sold to customers, $536,000. Disbursed $25,000 for the rent of the store. Add to Prepaid Rent. Disbursed $165,000 for wages through November. Disbursed $75,000 for miscellaneous expenses such as utilities, advertising, and legal help. (Debit Miscellaneous Expenses.) On July 1, 20X1, loaned $40,000 to the office manager. He signed a note that will mature on July 1, 20X2, together with interest at 5% per annum. Interest for 20X1 is due on December 31, 20X1. On August 1, 20X1, borrowed $80,000 from a supplier. The note is payable in 4 years. Interest is payable yearly on December 31 at a rate of 6% per annum. Collections on accounts receivable, $692,000. Payments on accounts payable, $472,000.

The following entries were made on December 31, 20X1: k. Recognized rent expense for 20X1: $3,000 of prepaid rent is applicable to 20X2; the remainder expired in 20X1. l. Depreciation for 20X1 was $6,000. m. Wages earned by employees during December were paid on December 31, $6,000. n. Interest on the loan made to the office manager was received. See transaction g. o. Interest on the loan from the supplier was disbursed. See transaction h. Required 1. Prepare journal entries in thousands of dollars. 2. Post the entries to T-accounts in the ledger, keying your postings by transaction letter. 3. Prepare a trial balance for the year ending December 31, 20X1.

 OBJECTIVES 3, 4

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 OBJECTIVES 3, 4, 5

3-42 Transaction Analysis, Trial Balance, and Closing Entries (Alternates are 3-37, 3-39 through 3-41, 3-43, and 3-44.) Husker Auto Glass, Inc., had the accompanying balance sheet values on January 1, 20X0: Husker Auto Glass, Inc. Balance Sheet Accounts, January 1, 20X0 Cash

$ 8,000

Accounts receivable

3,000

Parts inventory

2,000

Prepaid rent

2,000

Trucks Equipment

36,000 8,000

Accumulated depreciation, trucks

$15,000

Accumulated depreciation, equipment

5,000

Accounts payable

1,900

Paid-in capital

20,000

Retained earnings

17,100

Total

$59,000

$59,000

During January, the following summarized transactions occurred: January

2 Collected accounts receivable, $2,500. 3 Rendered services to customers for cash, $4,200 ($700 collected for parts, $3,500 for labor). Use two accounts, Parts Revenue and Labor Revenue. 3 Cost of parts used for services rendered, $300. 7 Paid legal expenses, $500 cash. 9 Acquired parts on open account, $900. 11 Paid cash for wages, $1,000. 13 Paid cash for truck repairs, $500. 19 Billed customer for services, $3,600 ($800 for parts and $2,800 for labor). 19 Cost of parts used for services rendered, $500. 24 Paid cash for wages, $1,400. 27 Paid cash on accounts payable, $1,500. 31 Rent expense for January, $1,000 (reduce Prepaid Rent). 31 Depreciation for January: trucks, $600; equipment, $200. 31 Paid cash to local gas station for gasoline for trucks for January, $300. 31 Paid cash for wages, $800.

Required 1. Enter the January 1 balances in T-accounts. Leave room for additional accounts. 2. Record the transactions in the journal. 3. Post the journal entries to the T-accounts. Key your entries by date. (Note how keying by date is not as precise as by transaction number or letter. Why? There is usually more than one transaction on any given date.) 4. Prepare a trial balance for the month ended January 31, 20X0. 5. Prepare closing entries.

 OBJECT IVES 3, 4

3-43 Transaction Analysis, Trial Balance (Alternates are 3-37, 3-39 through 3-42, and 3-44.) McDonald’s Corporation is a well-known fast-food restaurant company. Examine the accompanying balance sheet values, which are based on McDonald’s condensed quarterly report and actual terminology:

ASSIGNMENT MATERIAL

133

McDonald’s Corporation Balance Sheet Values, September 30, 2011 ($ in millions) Cash Accounts and notes receivable Inventories Prepaid expenses Property and equipment, at cost Other assets Accumulated depreciation Notes and accounts payable Other liabilities Paid-in capital Retained earnings Other stockholders’ equity*

$ 2,389 1,204 115 714 35,220 5,518

Total

$72,598

$12,882 750 18,189 5,447 35,330 27,438 $72,598

*These negative stockholders’ equity items will be explained in later chapters.

Consider the following assumed partial summary of transactions for October 2011 ($ in millions): a. Revenues in cash, company-owned restaurants, $1,550. b. Revenues, on open account from franchised restaurants, $550. Open a separate revenue account for these sales. c. Inventories acquired on open account, $827. d. Cost of the inventories sold, $820. e. Depreciation, $250. (Debit Depreciation Expense.) f. Paid rent and insurance premiums in cash in advance, $142. (Debit Prepaid Expenses.) g. Prepaid expenses expired, $137. (Debit Operating Expenses.) h. Paid other liabilities in cash, $163. i. Cash collections on receivables, $590. j. Cash disbursements on notes and accounts payable, $747. k. Paid interest expense in cash, $110. l. Paid other expenses in cash, mostly payroll and advertising, $1, 010. (Debit Operating Expenses.) Required 1. Record the transactions in the journal. 2. Enter beginning balances in T-accounts. Post the journal entries to the T-accounts. Key your entries with the transaction letters used here. 3. Prepare a trial balance for the month ended October 31, 2011. 3-44 Transaction Analysis, Trial Balance (Alternates are 3-37 and 3-39 through 3-43.) Columbia Sportswear is one of the largest outdoor apparel, footwear, accessories, and equipment companies in the world. Examine the following balance sheet values, which are slightly revised from Columbia’s annual report: Columbia Sportswear Balance Sheet Values December 31, 2011 ($ in millions) Cash Accounts receivable Prepaid expenses Inventories

$ 241.0 351.5 36.4 365.2

Property and equipment, net

250.9

Other assets

137.5

Accounts payable

$ 149.0

Other liabilities

159.0

Paid-in capital

49.9 1,024.6

Retained earnings Total

$1,382.5

$1,382.5

 OBJECTIVES 3, 4

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Consider the following assumed partial summary of transactions for the first three months of 2012 ($ in millions): a. b. c. d. e. f. g. h. i. j.

Acquired inventories for $286.9 on open account. Sold inventories that cost $239.7 for $423.5 on open account. Collected $410.6 on open account. Disbursed $231.3 on open accounts payable. Paid cash of $15 for advertising expenses. (Use an Operating Expenses account.) Paid rent and insurance premiums in cash in advance, $11. (Use a Prepaid Expenses account.) Prepaid expenses expired, $18. (Use an Operating Expenses account.) Other liabilities paid in cash, $22.3. Interest expense of $4 was paid in cash. (Use an Interest Expense account.) Depreciation of $16 was recognized. [Use an Operating Expenses account; instead of creating an Accumulated Depreciation account, reduce the Property and Equipment (net) account directly.] k. Additional shares were sold for $6 in cash. (Record as an increase to Paid-in Capital.) Required 1. Record the transactions in the journal. 2. Enter beginning balances in T-accounts. Post the journal entries to the T-accounts. Key your entries with the transaction letters used here. 3. Prepare a trial balance for the three months ended March 31, 2012. 4. Explain why cash increased during the first three months of 2012.

 OBJECT IVE 5

3-45 Preparation of Financial Statements from Trial Balance PepsiCo produces snack foods such as Fritos and Lay’s potato chips, as well as beverages such as Pepsi and Mug Root Beer. The company had the following condensed trial balance as of September 3, 2011, for the nine months ended September 3, 2011 ($ in millions): PepsiCo Trial Balance

Current assets

Debits $ 17,834

Property and equipment, net

20,737

Intangible assets, net

34,131

Other assets

Credits

2,676

Current liabilities

$ 17,565

Long-term debt and other liabilities

33,810

Stockholders’ equity*

21,379

Net revenue

46,346

Cost of sales

21,862

Selling, general, and administrative expenses

16,995

Other expenses

2,461

Cash dividends declared

2,404

Total

$119,100

$119,100

*Includes beginning retained earnings.

1. Prepare PepsiCo’s income statement for the nine months ended September 3, 2011. 2. Prepare PepsiCo’s balance sheet as of September 3, 2011.

ASSIGNMENT MATERIAL

3-46 Accumulated Depreciation Johnson Matthey, the British specialty chemical company, had the following balances on its March 31, 2011, balance sheet [£ (British pound) in millions]: Tangible fixed assets, at cost Less: Accumulated depreciation Net tangible fixed assets

 OBJECTIVE 3

£1,755.0 847.3 £ 907.7

Suppose that Johnson Matthey depreciates most of its tangible fixed assets over 15 years. 1. What is the approximate average age of Johnson Matthey’s tangible fixed assets? 2. Johnson Matthey invested £115.1 million in tangible fixed assets during the prior year. Using this information and your answer to part 1, explain whether Johnson Matthey is growing or depleting its supply of fixed assets. 3-47 Effects of Errors Toyota Motor Corporation is one of the world’s largest automakers. The company reported pretax profit of ¥291,468 million in fiscal 2010 and pretax profit of ¥563,290 million in fiscal 2011. Assume that there are no income taxes so that these amounts are also after-tax amounts. Consider the following two independent scenarios.

 OBJECTIVE 6

1. Suppose Toyota built a new factory that began production at the beginning of fiscal 2010. Cost of the factory was ¥600,000 million, and its life was estimated to be 20 years. If Toyota neglected to take depreciation on the factory in fiscal 2010 but correctly charged one year’s depreciation in fiscal 2011, what misstatements would exist on Toyota’s 2010 financial statements? On its 2011 financial statements? 2. Suppose in fiscal 2010 Toyota incorrectly recorded ¥100,000 million of sales for orders of automobiles that were not delivered, and thus the revenue was not earned, until fiscal 2011. What errors would there be in the fiscal 2010 financial statements? In the fiscal 2011 financial statements? Assume that cost of goods sold averages 75% of sales. 3-48 Journal Entries, Posting Sony Corporation is a leading international supplier of audio and video equipment. The Sony annual report at the end of the 2011 fiscal year included the following balance sheet items (Japanese yen in billions): Cash Receivables Prepaid expenses Land Accounts payable, trade

¥1,014 744 603 146 793

Consider the following assumed transactions that occurred immediately subsequent to the balance sheet date (Japanese yen in billions): a. Collections from customers

¥567

b. Purchase of land for cash

20

c. Purchase of 2-year insurance policy for cash

12

d. Disbursements to trade creditors

499

 OBJECTIVE 3

135

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CHAPTER 3 • RECORDING TRANSACTIONS

1. Enter the five account balances in T-accounts. 2. Journalize each transaction. 3. Post the journal entries to T-accounts. Key each posting by transaction letter.

 OBJECT IVE 3

3-49 Reconstructing Journal Entries, Posting (Alternate is 3-50.) Procter & Gamble has brands such as Tide, Pampers, and Gillette. A partial income statement from its annual report for the fiscal year ending in June 30, 2011, showed the following actual numbers and nomenclature ($ in millions): Net sales

$82,559

Costs and expenses Cost of products sold

40,768

Selling, general, and administrative expense

25,973

Interest expense

831

Other income, net

(202) 3,392

Income taxes Total expenses Net earnings

70,762 $11,797

1. Prepare six summary journal entries for the given data. Label your entries a through f. Omit explanations. For simplicity, assume that all transactions (except for cost of products sold) were for cash. 2. Post to T-accounts in a ledger for all affected accounts. Key your postings by transaction letter.

 OBJECT IVE 3

3-50 Reconstructing Journal Entries, Posting (Alternate is 3-49.) Lowe’s Companies, Inc., operates more than 1,700 home improvement retail stores in 50 states and Canada. A condensed income statement from its annual report for the nine months ending October 28, 2011, showed the following actual numbers and nomenclature ($ in millions): Net sales

$38,579

Expenses Cost of sales

$25,208

Selling, general, and administrative expenses

9,583

Other expenses

2,271

Total costs and expenses Pretax earnings

37,062 $ 1,517

1. Prepare four summary journal entries for the given data. Label your entries a through d. Omit explanations. For simplicity, assume that all transactions except for cost of sales were for cash. 2. Post to T-accounts in a ledger for all affected accounts. Key your postings by transaction letter.

 OBJECT IVE 3

3-51 Plant Assets and Accumulated Depreciation Norsk Hydro, the Norwegian-based global supplier of aluminum and aluminum products, had the following in its January 1, 2011, balance sheet (in millions of Norwegian Kroner, NOK): Total property, plant, and equipment, at cost Less: Accumulated depreciation Property, plant, and equipment, net

NOK60,754 35,905 NOK24,849

ASSIGNMENT MATERIAL

1. Open T-accounts for (a) Property, Plant, and Equipment; (b) Accumulated Depreciation, Property, Plant, and Equipment; and (c) Depreciation Expense. Enter the balance sheet amounts into the T-accounts. 2. Assume that in 2011 Norsk Hydro purchased or sold no assets and that depreciation expense for 2011 was NOK2,952 million. Depreciation was the only item affecting the Property, Plant, and Equipment account in 2011. Prepare the journal entry, and post to the T-accounts. 3. Prepare the property, plant, and equipment section of Norsk Hydro’s balance sheet at the end of 2011. 4. Land comprises $1,170 million of Norsk Hydro’s property, plant, and equipment, and land is not depreciated. Comment on the age of the company’s depreciable assets—that is, all property, plant, and equipment except land—at the December 31, 2011, balance sheet date. 3-52 Management Incentives, Financial Statements, and Ethics Alicia Perez was controller of the vascular products division of a major medical instruments company. On December 30, 2012, Perez prepared a preliminary income statement and compared it with the 2012 budget:

 OBJECTIVE 5

Vascular Products Division Income Statement, for the Year Ended December 31, 2012 ($ in thousands)

Sales revenue

Budget $1,200

Preliminary Actual $1,600

Cost of goods sold

600

800

Gross margin

600

800

Other operating expenses

450

500

$ 150

$ 300

Operating income

The top managers of each division had a bonus plan that paid each a 10% bonus if operating income exceeded budgeted income by more than 20%. It was obvious to Perez that the vascular products division had easily exceeded the $180,000 of operating income needed for a bonus. In fact, she wondered if it would not be desirable to reduce operating income this year—after all, the higher the income this year, the higher top management is likely to set the budget next year. Besides, if some of December’s sales could just be held back and recorded in January, the division would have a running start on next year. Perez had always been a team player, and she saw holding back sales as the best strategy for her team of managers. Therefore, she recorded only $1,500,000 of sales in 2012—the other $100,000 was recorded as January 2013 sales. Operating income for 2012 then became $250,000 and there was a head start of $50,000 on 2013’s operating income. Comment on the ethical implications of Perez’s decision.

Collaborative Learning Exercise 3-53 Income Statement and Balance Sheet Accounts Form teams of two persons each. Each person should make a list of 10 account names, with approximately one-half being income statement accounts and one-half being balance sheet accounts. Give the list to the other member of the team, who is to write beside each account name the financial statement (I for income statement or B for balance sheet) on which it belongs. If there are errors or disagreements in classification, discuss the account and come to an agreement about which financial statement it belongs to.

 OBJECTIVE 1

Analyzing and Interpreting Financial Statements 3-54 Financial Statement Research Select the financial statements of any company.

 OBJECTIVE 3

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CHAPTER 3 • RECORDING TRANSACTIONS

1. Prepare an income statement in the following format: Total sales (or revenue) Cost of goods sold Gross margin Other expenses Income before income taxes Be sure to include all revenue in the first line and all expenses (except income taxes) in either cost of goods sold or other expenses. 2. Prepare three summary journal entries for the income statement data you prepared. Use the given account titles and label your entries a, b, and c. Omit explanations. For simplicity, assume that all “other expenses” were paid in cash and all sales are on credit. 3. Post to T-accounts in a ledger for all affected accounts. Key your postings by transaction letter.

 OBJECT IVE 3

3-55 Analyzing Starbucks’ Financial Statements Using either the SEC EDGAR Web site or Starbucks’ Web site, find Starbucks’ 2011 financial statements. Note the following summarized items (dollars in millions) from the income statement for the year ended October 2, 2011: Net revenues Cost of sales including occupancy costs Store and other operating expenses Other income Interest expense Pretax income

$11,700.4 $4,949.3 5,226.5 (319.8) 33.3

9,889.3 1,811.1

Income taxes

565.4

Net earnings

$ 1,245.7

1. Prepare six summary journal entries for the given data. Use Starbucks’ account titles and label your entries a through f. Omit explanations. For simplicity, assume all transactions (except for cost of sales) were for cash. Assume cost of sales is 70% of the “cost of sales including occupancy costs,” whereas occupancy costs are 30% and are paid in cash. 2. Starbucks’ balance sheet shows $2,355.0 million of Property, Plant, and Equipment, net. Explain what the term “net” means and find both gross and net amounts for Property, Plant, and Equipment.

 OBJECT IVE 3

3-56 Analyzing Financial Statements Using the Internet: Delta Go to www.delta.com. In the menu at the bottom of the home page, click on About Delta. Then locate Delta’s Annual Reports under Investor Relations. Select the most recent annual report. Answer the following questions about Delta Air Lines, Inc.: 1. Locate Delta’s accumulated depreciation balance on the balance sheet or in its property and equipment footnote. What is the dollar magnitude of accumulated depreciation at year end? Does this represent an expense for Delta? Why does Delta keep track of accumulated depreciation? 2. Does Delta include a line for depreciation on its Consolidated Statements of Operations? If so, what is the dollar amount reported? Locate the Property and Equipment (Long-Lived Assets) footnote. Does the footnote include a dollar amount for depreciation expense? If so, what is the dollar amount reported? If both numbers are reported, do they agree?

ASSIGNMENT MATERIAL

3. Locate Cash and Cash Equivalents at the end of the year on the Consolidated Balance Sheet. How much did cash and cash equivalents increase or decrease during the past year? Where would you look for a detailed explanation of the change in Cash? 4. Locate Shareholders’ Equity on the Consolidated Balance Sheets. Does Delta’s common stock have a par value per share? What is it? Consider two amounts: Common Stock and Additional Paid-in Capital. What is the dollar amount reported in each of these line items. How did these amounts arise? 5. Again, locate Shareholders’ Equity on the Consolidated Balance Sheets. What does Delta report for Retained Earnings? Did Retained Earnings increase or decrease during the year? What could cause this change in Retained Earnings?

139

4

Accrual Accounting and Financial Statements

CHANCES ARE YOU or someone you know is one of the millions of customers who have purchased outdoor wear or accessories made by Columbia Sportswear, the Oregon-based designer and manufacturer of active outdoor apparel. Columbia is one of the largest outdoor apparel, footwear, accessories, and equipment companies in the world. The company has an international reputation based on innovation, quality, performance, functionality, and value—factors that have won over discerning shoppers. Columbia Sportswear’s management team is concerned about these factors, and takes pride in its high customer satisfaction ratings. However, customer satisfaction alone does not pay their salaries, so managers also need to know whether the company is making a profit. Do managers have to turn to complicated equations and formulas to determine the company’s profit? No, they can turn to Columbia Sportswear’s financial statements—just as we can.

LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Understand the role of adjustments in accrual accounting. 2 Make adjustments for the expiration or consumption of unexpired costs. 3 Make adjustments for the earning of revenues received in advance.

4 Make adjustments for the accrual of unrecorded expenses. 5 Make adjustments for the accrual of unrecorded revenues. 6 Describe the sequence of steps in the recording process and relate cash flows to adjusting entries.

7 Prepare a classified balance sheet and use it to assess short-term liquidity. 8 Prepare single- and multiple-step income statements. 9 Use ratios to assess profitability.

Information in Columbia Sportswear’s financial statements comes directly from the company’s financial accounting system, which generates information useful in assessing the company’s financial success. If you want to buy Columbia Sportswear’s stock instead of its clothes, you need information about the company’s financial position and prospects in order to judge whether it is a wise investment. To read and understand Columbia’s financial statements and compare them to the statements of other companies, you must first understand the fundamentals of financial accounting. This includes the use of accrual accounting and the adjusting entries required before financial statements are prepared. Financial managers in entities as large as IBM and as small as Chez José Mexican Restaurant, in nonprofit as well as for-profit organizations, and located in Spain, China, the United States, or elsewhere in the world, must understand the consequences of these adjustments when interpreting financial statements.



Columbia Spor tswear distributes and sells products in more than 100 countries through a mix of wholesale distribution channels, direct-to-consumer channels, independent distributors, and licensees. The flagship store is located in downtown Portland, Oregon. Columbia’s financial statements reflect the results of all this business activity, using the principles of accrual accounting discussed in this chapter.

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 OBJECT IVE 1 Understand the role of adjustments in accrual accounting.

explicit transactions Observable events such as cash receipts and disbursements, credit purchases, and credit sales that trigger the majority of day-to-day routine journal entries.

implicit transactions Events, such as the passage of time, that do not generate source documents or any visible evidence that the event actually occurred. We do not recognize such events in the accounting records until the end of an accounting period.

adjustments (adjusting entries) End-of-period entries that assign the financial effects of implicit transactions to the appropriate time periods.

accrue To accumulate a receivable (asset) or payable (liability) during a given period, even though no explicit transaction occurs, and to record a corresponding revenue or expense.

Adjustments to the Accounts Accountants record the majority of a company’s transactions in journals and ledgers as the events occur. However, no observable event triggers transactions such as those discussed in Chapter 3 for depreciation and the expiration of prepaid rent. The difference between these transactions and the majority of the transactions we have recorded to date stems from how obvious or explicit they are. Explicit transactions are observable events, such as cash receipts and disbursements, credit purchases, and credit sales that trigger the majority of day-to-day routine journal entries. Every explicit transaction is prompted by an economic event that has occurred, and we know that the accountant must make an entry to record the event. Entries for these transactions are supported by source documents, for example, sales slips, purchase invoices, employee payroll checks, or other tangible evidence. Note that not all explicit transactions require an actual exchange of goods and services between the company and another party. For example, the loss of assets due to fire or theft is an explicit transaction, even though no market exchange occurs. In all cases, though, a specific observable event triggers the need to record a journal entry. Implicit transactions are events, such as the passage of time, that do not generate source documents or any visible evidence that the event actually occurred. Because there is no specific notification to record such events, accountants do not formally recognize them in the accounting records until the end of an accounting period. For example, accountants prepare entries for depreciation expense or the expiration of prepaid rent from special schedules or memorandums at the end of an accounting period. An explicit event did not trigger such entries. Accountants recorded the related explicit transaction at the time the company purchased the depreciable asset or made the initial rent payment. We call the end-of-period entries that record these implicit events adjustments. Adjustments (also called adjusting entries) assign the financial effects of implicit transactions to the appropriate time periods. Thus, adjustments occur at periodic intervals, usually at the end of the accounting cycle when accountants are about to prepare the financial statements. They make adjustments by recording journal entries in the general journal and then posting them to the general ledger. After recognizing these adjustments for implicit transactions, they update the balances in the general ledger accounts through the end of the period and use these updated balances for preparing financial statements. Adjusting entries are at the heart of accrual accounting. Accrue means to accumulate a receivable (asset) or payable (liability) during a given period, even though no explicit transaction occurs. The receivables or payables increase as time passes, even though no physical assets change hands. In order to maintain the equality of the balance sheet equation, as we accumulate the receivable or payable on the balance sheet, we must also recognize a revenue or expense on the income statement. What routine business transactions require accruals? Examples are the wages earned by employees but not yet paid and the interest owed on borrowed money before the scheduled interest payment date. First, consider wages. Usually we recognize wage expense when a company pays its employees. However, suppose a company pays wages on Friday, and its accounting period ends on the following Wednesday. By the close of business on Wednesday, employees have earned 3 days’ wages, but no explicit event has prompted the company to record an entry. The company must make an adjustment to recognize the wages for Monday, Tuesday, and Wednesday as an increase in both Wages Payable and Wage Expense. Because accruals are not based on explicit transactions, we do not record them on a day-to-day basis. Rather, we make adjusting entries at the end of each accounting period to recognize unrecorded but relevant accruals. You will see that each adjustment affects both an income statement account and a balance sheet account. Adjusting entries never affect cash, as any entry with a cash impact is the result of an explicit transaction. The goal of adjusting entries is to ensure that all the company’s assets, liabilities, and stockholders’ equity accounts are properly reflected in the financial statements. In the adjusting process, we consider whether the passage of time or other events has led to the creation of assets, the consumption of assets, or the creation or discharge of liabilities. Adjustments help match revenues and expenses to the appropriate accounting period and ensure the balance sheet correctly states assets and liabilities. For example, consider a $29 million annual contract for a baseball star, such as Alex Rodriguez, for the 2012 season. If the team pays all $29 million in cash in 2012, there is an explicit transaction. The team records a reduction in cash of $29 million and an expense of $29 million. In contrast, suppose the team pays only $20 million in cash and defers $9 million until 2013 or later. The $20 million cash

I. EXPIRATION OR CONSUMPTION OF UNEXPIRED COSTS

payment is an explicit transaction that the team records as an expense in 2012. Because no explicit transaction for the additional $9 million occurs during 2012, the team does not routinely enter it into the accounting record. However, Rodriguez has earned the full $29 million as a result of playing the whole season and the team must eventually pay the remaining $9 million, so a liability exists. Further, the team incurred the entire $29 million for the benefit of the 2012 season, so the $9 million deferred payment is an expense for 2012. Thus, at the end of the period, when the team prepares the 2012 financial statements, an adjustment is necessary to record the deferred $9 million payment as an expense and to record a $9 million liability for its payment. The principal adjustments arise from four basic types of implicit transactions: I. II. III. IV.

Expiration or consumption of unexpired costs Earning of revenues received in advance Accrual of unrecorded expenses Accrual of unrecorded revenues Let us now examine each of these four categories in detail.

I. Expiration or Consumption of Unexpired Costs Some costs expire due to the passage of time. For example, initially a company engages in an explicit transaction that creates an asset. As the company consumes the asset, it must make an adjustment to reduce the asset and to recognize an expense. The key characteristic of unexpired costs is that an explicit transaction in the past created an asset, and subsequent implicit transactions recognize the consumption of this asset. For example, refer back to page 104 of Chapter 3. Biwheels paid $6,000 in January to cover rent for the months of January, February, and March. The company initially recorded $6,000 of Prepaid Rent as an asset. As each day passed, Biwheels incurred rent expense and the asset declined in value. However, there is no benefit to recording daily adjusting entries. Rather, Biwheels made a $2,000 adjustment at the end of each month to reflect the gradual expiration of the rent costs. The adjusting entry reduced the asset, Prepaid Rent, and increased Rent Expense. Another example of adjusting for asset expiration is the expensing of Office Supplies Inventory. Suppose a company just initiating operations purchases $10,000 of Office Supplies Inventory on March 1, 2013. The company had no supplies inventory on hand prior to this purchase. At the time of the purchase an explicit transaction has occurred and the company records an increase (debit) to Office Supplies Inventory and a decrease (credit) to Cash. The journal entry to record this purchase is as follows: Office supplies inventory Cash

.....................................

10,000

...........................................................

10,000

At the end of March, the company determines that it has used $1,500 of the Office Supplies Inventory acquired on March 1. This requires the following adjusting entry to increase Office Supplies Expense (debit) and reduce Office Supplies Inventory (credit): Office supplies expense.......................................... Office supplies inventory...................................

1,500 1,500

After recording this adjusting entry, the balance sheet will show only $8,500 ($10,000 – $1,500) in Office Supplies Inventory, and the income statement will show an expense of $1,500. Will failure to record an adjusting entry cause the balance sheet and income statement to be incorrect? Yes. Even though the balance sheet will balance, both the income statement and the balance sheet will be in error. If the company fails to make the preceding adjusting entry, Office Supplies Inventory is overstated by $1,500 and Office Supplies Expense is understated by $1,500. Understated expenses result in overstated net income and overstated Retained Earnings, a stockholders’ equity account. Another example of the expiration of unexpired costs is the recording of Depreciation Expense and Accumulated Depreciation. You can review the accounting for depreciation on page 105 of Chapter 3.

 OBJECTIVE 2 Make adjustments for the expiration or consumption of unexpired costs.

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 OBJECTIVE 3 Make adjustments for the earning of revenues received in advance.

unearned revenue (revenue received in advance, deferred revenue) Represents cash received from customers who pay in advance for goods or services to be delivered at a future date.

II. Earning of Revenues Received in Advance Just as a company acquires assets and recognizes the related expense over time as it uses the assets, it may receive revenue in advance and then earn the revenue over time. Unearned revenue (also called revenue received in advance or deferred revenue) represents cash received from customers who pay in advance for goods or services that the company promises to deliver at a future date. The company receives cash before it earns the related revenue. This commitment to provide goods or services in the future is a liability, and the company must record both the receipt of cash and the liability. For instance, airlines often require advance payment for tickets. American Airlines recently showed a balance of almost $4.4 billion in an unearned revenue account labeled Air Traffic Liability. Over time, as customers take the flights they have paid for, American reduces the liability and increases revenue. The analysis of adjusting entries for unearned revenue is easier to understand if we visualize the financial positions of both parties to a contract. For example, recall the Biwheels Company’s January advance payment of $6,000 for 3 months’ rent. Compare the financial impact on Biwheels Company with the impact on the company that owns the property (the landlord), who received the rental payment: Owner of Property (Landlord, Lessor) A

Cash (a) Explicit transaction (advance payment of 3 months’ rent) (b) January adjustment (for 1 month rent) (c) February adjustment (for 1 month rent) (d) March adjustment (for 1 month rent)

+6,000

=

L + Unearned Rent = Revenue +

Biwheels Company (Tenant, Lessee)

SE

A

Rent Revenue

Cash -6,000

+

= Prepaid Rent

=

+6,000

=

L

+

SE Rent Expense

=

+6,000

=

-2,000

+2,000

-2,000

=

-2,000

=

-2,000

+2,000

-2,000

=

-2,000

=

-2,000

+2,000

-2,000

=

-2,000

The journal entries for (a) and (b) follow: OWNER (LANDLORD) (a) Cash ....................................................... Unearned rent revenue (b) Unearned rent revenue Rent revenue

6,000

........................... .............................

6,000 2,000

.........................................

2,000

[Entries for (c) and (d) are the same as for (b).] BIWHEELS COMPANY (TENANT) (a) Prepaid rent ............................................. 6,000 Cash ..................................................... (b) Rent expense

..........................................

Prepaid rent

..........................................

6,000 2,000 2,000

[Entries for (c) and (d) are the same as for (b).]

We are already familiar with the analysis from Biwheels’ point of view. The $2,000 monthly entries for Biwheels are examples of the first type of adjustment, the expiration of a prepaid asset. From the viewpoint of the landlord, transaction (a) is an explicit transaction that recognizes the receipt of cash and an increase in Unearned Rent Revenue, a liability. Why record a liability? Because the landlord is now obligated to either deliver the rental services or refund the money if the services are not delivered. This account could be called Rent Collected in Advance or Deferred Rent Revenue instead of Unearned Rent Revenue. Regardless of the title, it is a liability account representing revenue collected in advance that the landlord has not earned, and it obligates the landlord to provide services in the future.

II. EARNING OF REVENUES RECEIVED IN ADVANCE

145

BUSINESS FIRST FRANCHISES AND REVENUE RECOGNITION In a franchise arrangement, a central organization, such as McDonald’s or the National Basketball Association, sells the right to use the company name and company products to a franchisee. The franchisee also receives the benefit of advertising through the larger company, along with management assistance and product development. The Web site www.azfranchises.com reports that 300 different business categories use franchising to distribute goods and services to U.S. consumers. In Entrepreneur Magazine’s 2012 Franchise 500 rankings, the top 50 companies include 16 fast-food or family service restaurants, 9 companies that provide residential or commercial cleaning services, 5 personal services companies such as fitness centers and beauty salons, and 3 hotels. One source estimates that there are 3,000 different franchise business companies operating more than 825,000 franchise outlets and employing more than 18 million people in the United States. The global franchising industry generates revenues of more than $2.1 trillion. Two of the largest global franchises are Subway with almost 35,000 outlets (30% outside the United States) and McDonald’s with more than 26,000 franchise outlets (57% outside the United States). One important difference between Subway and McDonald’s is that all of Subway’s locations are franchises, while McDonald’s operates 6,400 companyowned locations in addition to its franchise outlets. Franchising raises an interesting accounting problem. How does the central organization account for the franchise fees? At first glance, it might seem clear that companies should record such fees as revenue when they receive the cash. However, under accrual accounting, companies should record revenue only after

two conditions have been satisfied: (1) the company has completed the “work,” that is, it has earned the revenue, and (2) there is reasonable assurance the company will actually collect the fee (it is realized in cash or will be collectible). The Rocky Mountain Chocolate Factory is a franchisor of premium chocolate shops with more than 315 stores in the United States, Canada, and the United Arab Emirates. It provides an example of a company that collects franchise fees before it performs the related work. Rocky Mountain Chocolate sells its franchisees area development rights that grant the franchisee the exclusive right to develop outlets in a specific geographic area. In return for these rights, Rocky Mountain Chocolate Factory receives an initial franchise fee. Should Rocky Mountain Chocolate record the fee as revenue when it receives the cash? It should not because Rocky Mountain Chocolate’s work is not done until the franchisee actually opens and operates the franchise stores. In the interim, Rocky Mountain Chocolate must report the fees as deferred revenue. McDonald’s is perennially named one of Entrepreneur Magazine’s top franchising organizations. In 2011, McDonald’s had $85.9 billion in system-wide sales, of which franchisees and affiliates generated $67.6 billion. However, when we look at the income statement, we see total revenue of only $27.0 billion—$18.3 billion from company-owned restaurants and $8.7 billion from franchisees and affiliates. Why? McDonald’s recognizes as revenues only the franchise fees, not the total product sales of its franchisees. Sources: www.entrepreneur.com/franchises; www.azfranchises.com/franchisefacts.htm; McDonalds 2010 Annual Report; Rocky Mountain Chocolate Factory 2010 Annual Report.

Notice that transaction (a) does not affect the landlord’s stockholders’ equity because it does not recognize any revenue. Recall from Chapter 2 that companies cannot recognize revenue on the income statement until it is both earned and realized. While the landlord realized the $6,000 when it received the cash, it had not earned any revenue as of that date. The landlord earns and recognizes the revenue over time as the adjusting entries in transactions (b), (c), and (d) are recorded. The landlord simultaneously decreases (debits) Unearned Rent Revenue and increases (credits) the stockholders’ equity account Rent Revenue. The net effect is an increase in stockholders’ equity at the time the owner recognizes the revenue. If the landlord fails to record the adjusting entry represented in (b), liabilities are overstated by $2,000 and revenues are understated by $2,000. Understated revenues result in an understatement of both net income and stockholders’ equity. Similarly, if Biwheels fails to record the adjusting entry represented previously, its assets are overstated by $2,000 and its expenses are understated by $2,000. When expenses are understated, both net income and stockholders’ equity are overstated.

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

By looking at both sides of the Biwheels rent contract, you can see that adjustment categories I and II are really mirror images of each other. Why? If a contract causes one party to record a Prepaid Expense, it will cause the other party to record Unearned Revenue. This basic relationship holds for any prepayment situation, from a 2-year fire insurance policy to a 5-year magazine subscription. In the case of the magazine subscription, the buyer initially recognizes a Prepaid Expense (asset) and uses adjustments to allocate the initial cost to an expense account over the term of the subscription. In turn, the seller, the magazine publisher, initially records a liability, Unearned Subscription Revenue, on receipt of payment for the 5-year subscription and uses adjustments to recognize the revenue over the subscription term. Another example is Starbucks, who lists Deferred Revenue of $449.3 million among its liabilities on October 2, 2011. Starbucks sells prepaid coffee cards (stored value cards) as well as gift certificates, both of which holders can redeem for a beverage or food item. Starbucks receives cash when customers purchase the card but cannot recognize revenue until the card or certificate is redeemed. Suppose Starbucks sells stored value cards and gift certificates totaling $10,000 on September 8. The explicit transaction creates a liability, Deferred Revenue, on the balance sheet and increases Cash. By the October 2 year-end, customers have redeemed cards and certificates worth $3,000. The company will recognize $3,000 in revenue on the income statement and reduce the Deferred Revenue account by $3,000. Another example of companies that receive revenue in advance is franchisors as described in the Business First box on page 145.

III. Accrual of Unrecorded Expenses  OBJECTIVE 4 Make adjustments for the accrual of unrecorded expenses.

Wages are an example of a liability that grows moment to moment as employees perform their duties. The services provided by employees represent expenses. It is unnecessary to make hourly, daily, or even weekly formal entries in the accounts for many accrued expenses, as the cost of such frequent recording would exceed the benefits. This is true, even though computers can perform these tasks effortlessly. The costs of computing are small, but in this case the benefits are even smaller. Accountants aggregate these costs only when they prepare financial statements, and this rarely needs to be done hourly or daily. Consequently, they make adjustments to bring each accrued expense (and corresponding liability) account up-to-date at the end of the accounting period, just before they prepare the formal financial statements. These adjustments are necessary to accurately match the expenses to the period in which they help generate revenues.

Accounting for Payment of Wages Most companies pay their employees on a predetermined schedule. Assume that Columbia Sportswear pays its employees each Friday for services rendered during that week. Consider the following sample calendar for January:

S M 7 14 21 28

1 8 15 22 29

January T W T 2 9 16 23 30

3 10 17 24 31

4 11 18 25

F

S

5 12 19 26

6 13 20 27

Because wage expenses accrue for an entire week before Columbia pays employees, wages paid on January 26 are compensation for work done during the week ended January 26. Assume the total wages paid on the four Fridays during January total $500,000, which is $125,000 per 5-day workweek, or $25,000 per day. Columbia makes routine entries for wage payments at the end of each week in January. As it pays wages, the company increases Wages Expense and decreases Cash. During the January shown in the preceding calendar, Columbia would pay wages on the 5th, 12th, 19th, and 26th. These events represent explicit transactions, prompted by

III. ACCRUAL OF UNRECORDED EXPENSES

writing payroll checks. At the end of January, the balance sheet shows the summarized amounts of these explicit transactions and their effect on the accounting equation:

(a) Routine entries for explicit transactions

A

=

L

+

SE

Cash

=

Wages Expense

–500,000

=

–500,000

Accounting for Accrual of Wages Assume that Columbia Sportswear prepares financial statements on a monthly basis. In addition to the $500,000 actually paid to employees during the month of January, Columbia owes $75,000 for employee services rendered during the last 3 days of the month. The company will not pay the employees for these services until Friday, February 2. To ensure an accurate accounting of Wages Expense for the month of January, Columbia must make an adjustment. Transaction (a) shows the total of the routine entries for the explicit payment of wages to employees during January, and transaction (b) shows the adjusting entry to accrue wages for Monday, January 29, through Wednesday, January 31. Transaction (b) recognizes both the expense and the liability. (a) Wages expense ....................................... Cash .................................................... (b) Wages expense ....................................... Accrued wages payable ..........................

500,000 500,000 75,000 75,000

If Columbia does not record transaction (b), both expenses and liabilities are understated by $75,000. Understated expenses result in the overstatement of both net income and stockholders’ equity. The total effect of wages on the balance sheet equation for the month of January, including transactions (a) and (b), is as follows: A

(a) Routine entries for explicit transactions

=

L

+

SE

Cash

=

Accrued Wages Payable

+

Wages Expense

–500,000

=

(b) Adjustment for implicit transaction, the accrual of unrecorded wages Total effects

–500,000

–500,000

=

+75,000

–75,000

=

+75,000

–575,000

The adjustment in entry (b) is the first adjusting entry we have examined that shows an expense offset by an increase in a liability instead of a decrease in an asset. The accountant’s problem is different for this type of accrual than it was for prepaid rent. With prepaid rent, there is a record in the accounts of an asset, and the accountant might recognize the necessity for an adjustment by asking the following question: Is the asset balance shown on the books correct or is an adjustment required to reduce it? With accrued wages there is no asset account to prompt such a question. However, because most end-of-period adjustments are routine, accountants know to check for adjustments such as expired rent and accrued wages because they experience these items every period. On February 2, Columbia will pay off the liability for the work performed during the last 3 days of January, together with the wages expense for February 1 and 2: Wages expense (February 1 and 2) ................ 50,000 Accrued wages payable ................................. 75,000 Cash ..................................................... To record wages expense for February 1 and 2 and to pay wages for the week ended February 2

125,000

147

148

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

These entries clearly demonstrate the matching principle. The routine entries and the adjusting entries match the wages expense to the periods in which they help generate revenues.

Accrual of Interest Other examples of accrued expenses include sales commissions, property taxes, income taxes, and interest on borrowed money. Interest is the “rent” paid for the use of money, just as rent is paid for the use of buildings. The interest accumulates (accrues) as time passes, regardless of when a company actually pays cash for interest. Assume that Columbia Sportswear borrowed $100,000 from Wells Fargo Bank on December 31, 2012. The terms of the loan require that Columbia repay the loan amount of $100,000 plus 6% interest on December 31, 2013. By convention, we express interest rates on an annual basis. We can calculate interest for any part of a year as follows: Principal * Interest rate * Fraction of a year = Interest Principal is the amount borrowed ($100,000). The interest rate is expressed as an annual percentage (6% or .06). For the full year, the interest expense is $100,000 * .06 * 1 = $6,000 As of January 31, 2013, Columbia has had use of the $100,000 bank loan for 1 month or onetwelfth of a year. Columbia owes the bank for the use of this money, and the amount owed has accrued for the entire month of January. The amount of interest owed is ($100,000 * .06 * 1/12) = $500. The monthly cost of the loan is $500. The interest is not due to be paid until December 31, 2013. However, at the end of January, Columbia is liable for 1 month of accrued interest. We analyze and record the adjustment in the same way as the adjustment for accrued wages: A

Adjustment to accrue January interest not yet recorded

=

=

L

+

SE

Accrued Interest Payable

Interest Expense

+500

–500

The adjusting journal entry is as follows: Interest expense .......................................... Accrued interest payable .........................

500 500

At the end of January, Columbia owes Wells Fargo $100,500, not $100,000. The adjusting entry matches the $500 interest expense with the period in which Columbia had the benefit of  the bank loan. If Columbia omits the adjusting entry, liabilities and expenses will both be understated at the end of January. Would the understatement of interest expense have other financial statement implications? Yes. If interest expense is understated, both net income and stockholders’ equity are overstated.

Accrual of Income Taxes As a company generates income, it accrues income tax expense. Income taxes exist worldwide, although rates and details differ from country to country. Corporations in the United States are subject to federal income taxes and, in most states, state income taxes. For many corporations, the federal plus state income tax rates are around 40%. Assuming a combined 40% tax rate, for every dollar of income a company makes, it accrues $.40 of income tax expense. Of course, the company does not pay $.40 in tax as it earns each dollar. Instead, taxes accrue over the accounting period, and the company makes an adjustment at the end of the period when it prepares financial statements.

IV. ACCRUAL OF UNRECORDED REVENUES

Companies use various account titles to denote income taxes on their income statements: Income tax expense, provision for income taxes, and income taxes are most common. For multinational firms, income tax expense may include tax obligations in every country in which the firm operates. In preparing income statements, most companies calculate a subtotal called income before income tax, earnings before income tax, or pretax income and then show income taxes as a separate income statement item just before net income. This arrangement is logical because income tax expense is based on pretax income. The 2010 Columbia Sportswear annual report contains the format adopted by the vast majority of companies. Income before income tax

income before income tax (earnings before income tax, pretax income) Income before the deduction of income tax expense.

$104,891,000 27,854,000

Income tax expense

$ 77,037,000

Net income

Adidas, which reports under IFRS, uses a similar format for its 2010 income: Profit before tax

€806,000,000 238,000,000

Income tax expense

€568,000,000

Profit after tax

IV. Accrual of Unrecorded Revenues Just as the realization of unearned revenues is the mirror image of the expiration of prepaid expenses, the accrual of unrecorded revenues is the mirror image of the accrual of unrecorded expenses. Because the company has not received cash, there is no explicit transaction to trigger a journal entry. However, according to the revenue recognition principle, revenues affect stockholders’ equity in the period a company earns them, not the period in which it receives cash. Thus, an adjustment is required to recognize revenues earned but not yet received. Consider the $100,000 loan Wells Fargo Bank made to Columbia Sportswear. As of January 31, 2013, Wells Fargo Bank has earned $500 in interest on the loan. The following tabulation shows the mirror-image effect: Wells Fargo Bank as a Lender A

=

Accrued Interest Receivable January interest

+500

L

+

Columbia Sportswear as a Borrower SE

A

=

L

Interest Revenue =

+500

=

+

SE

Accrued Interest Payable

Interest Expense

+500

–500

Another example of accrued revenues and receivables is “unbilled” fees. Attorneys, public accountants, physicians, and advertising agencies may earn hourly fees during a particular month but not issue bills to their clients until the completion of an entire contract or engagement. Under the accrual basis of accounting, a company should record such revenues in the month in which it earns the revenues, not at a later time. For example, assume that a law firm renders $10,000 of services during January but does not bill for these services until March 31. Before the firm prepares financial statements for January, it makes the following adjustment for unrecorded revenues for the month: A

=

Accrued (Unbilled) Fees Receivable Adjustment for fees earned

+10,000

L

+

SE Fee Revenue

=

+10,000

149

 OBJECTIVE 5 Make adjustments for the accrual of unrecorded revenues.

150

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

The journal entry to record these unrecorded revenues is shown here:

Accrued (unbilled) fees receivable ..................

10,000

Fee revenue ..........................................

10,000

What happens if the law firm does not make this adjusting entry? Assets and revenues are both understated by $10,000. Understated revenues result in understated net income and understated stockholders’ equity. Utility companies often recognize unbilled revenues for utility services provided but not yet billed to customers. In fact, as of January 1, 2012, Northwest Natural, a utility that provides natural gas to more than 674,000 residential and business customers throughout Oregon and southwestern Washington, included almost as much Accrued Unbilled Revenue as Accounts Receivable among its current assets:

Accounts receivable

$77,449,000

Accrued unbilled revenue

$61,925,000

Ethics, Unearned Revenue, and Revenue Recognition

conservatism Selecting methods of measurement that anticipate expenses and liabilities and defer recognition of revenues and assets, yielding lower net income, lower assets, and lower stockholders’ equity.

Deciding when unearned revenue becomes earned can pose ethical dilemmas for accountants. Suppose you are the accountant for a small company that receives a $100,000 cash payment on December 15, in exchange for a commitment to provide various consulting services at a later date. At the time the company receives the cash, you appropriately record an increase in Cash and an increase in the liability account, Unearned Revenue. As we saw earlier in this chapter, as the company provides the services, the appropriate accounting treatment is to decrease the Unearned Revenue account and recognize revenue on the income statement. When you review the contract on December 31, you conclude that the company has performed $65,000 worth of the $100,000 in consulting services. You propose an adjusting entry to recognize $65,000 in revenue (credit) and to reduce the Unearned Revenue account (debit) by $65,000. Your boss, the CFO of the company, insists that the company has completed only $10,000 in services. He argues that recognition of only $10,000 in revenue is a more conservative estimate of the percentage of services performed. In addition, he reminds you that accountants should be conservative. In this context, conservatism means selecting methods of measurement that anticipate expenses and liabilities and defer recognition of revenues and assets, yielding lower immediate net income, lower assets, and lower stockholders’ equity. Your boss argues that financial statements are less likely to mislead users if balance sheets report assets at lower rather than higher amounts, report liabilities at higher rather than lower amounts, and if income statements report lower rather than higher net income. He claims that it is unethical to overstate revenue and net income and understate liabilities, and that his lower estimate of $10,000 conservatively states revenue and net income. You have overheard a conversation at the water cooler suggesting that the company expects sales to slow in the coming year, and you wonder whether that forecast has anything to do with the CFO’s estimate. Could the CFO be attempting to “save” revenue to record in the coming year? Should you prepare an income statement that recognizes $10,000 of revenue associated with the service contract or insist on recording $65,000? The issues in this scenario are complex. It is often difficult to determine exactly when consulting services have been performed. Two people, both acting in good faith, may give different estimates of the completion of these services. The $10,000 is a more conservative estimate of revenue earned. However, by reporting lower net income in the current period, the company will report higher net income in the following period. If the CFO’s $10,000

THE ADJUSTING PROCESS IN PERSPECTIVE

151

estimate is intended solely to manipulate the company’s revenue and earnings trend, use of that estimate is unethical.

 OBJECTIVE 6

The Adjusting Process in Perspective

Describe the sequence of steps in the recording process and relate cash flows to adjusting entries.

Chapter 3 presented the various steps in the recording process as follows:

Transaction Documentation

Journal

Ledger

Trial Balance

Financial Statements

Step 1

Step 2

Step 3

Step 4

Step 5

The final aim of the recording process is the preparation of accurate financial statements prepared on the accrual basis. To accomplish this goal, the process must incorporate adjusting entries to record implicit transactions. When we consider the adjustments, we can further divide the final three steps in the recording process as follows: Ledger

Unadjusted Trial Balance

Journalize and Post Adjustments

Adjusted Trial Balance

Financial Statements

Step 3

Step 4a

Step 4b

Step 4c

Step 5

As you review these steps, remember that each adjusting entry affects at least one income statement account, a revenue or an expense, and one balance sheet account, an asset or a liability. Adjusting entries never debit or credit cash. Why? If transactions affect cash, they are explicit transactions that companies must record as they occur. The end-of-period adjustment process is reserved for implicit transactions that are a necessary component of the accrual basis of accounting. Cash flows—that is, explicit transactions involving cash receipts or cash disbursements— may precede or follow the adjusting entry that recognizes the related revenue or expense. The diagrams that follow underscore the basic differences between the cash flows and the accrual accounting entries. Entries for adjustments I and II, expiration or consumption of unexpired costs and earning of revenues received in advance, generally occur subsequent to the related cash flows. For example, at the time a company receives or disburses cash for rent, only the balance sheet is affected. The subsequent adjusting entry records the later impact on the income statement.

Advance Cash Payments for Future Services to Be Received

Advance Cash Collections for Future Services to Be Rendered

Create

Create

Noncash Assets in the Balance Sheet

Liabilities in the Balance Sheet

Transformed by Adjustments into

Transformed by Adjustments into

Expenses in the Income Statement

I. Expiration or Consumption of Unexpired Costs

Revenues in the Income Statement

II. Earning of Revenues Received in Advance

We make the entries for adjustments III and IV, accrual of unrecorded expenses and accrual of unrecorded revenues, before the related cash flows. The income statement is affected before the cash receipts and disbursements occur. The accounting entity computes the amount of goods or services provided or received prior to any cash receipt or payment. Exhibit 4-1 summarizes the major adjusting entries.

152

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

Passing of Time and the Continuous Use of Services

Recorded by Adjustments as Increases in

Expenses in the Income Statement

and

Liabilities in the Balance Sheet

Passing of Time and the Continuous Rendering of Services

Recorded by Adjustments as Increases in

Decreased by

Later Cash Payments

III. Accrual of Unrecorded Expenses

Later Cash Collections

IV. Accrual of Unrecorded Revenues

Revenues in the Income Statement

and

Noncash Assets in the Balance Sheet

Decreased by

EXHIBIT 4-1 Summary of Adjusting Entries Adjusting Entry

Type of Account Debited

Type of Account Credited

I. Expiration or consumption of unexpired costs

Expense

Prepaid expense, accumulated depreciation

II. Earning of revenues received in advance

Unearned revenue

Revenue

III. Accrual of unrecorded expenses

Expense

Payable

IV. Accrual of unrecorded revenues

Receivable

Revenue

THE ADJUSTING PROCESS IN PERSPECTIVE

Summary Problem for Your Review PROBLEM 1. Chan Audio Company is a retailer of stereo equipment that began operations on January 1, 20X0. One month later, on January 31, 20X0, the company’s unadjusted trial balance consists of the following accounts and account balances:

Cash Accounts receivable Note receivable Merchandise inventory Prepaid rent Store equipment

$ 71,700 160,300 40,000 250,200 15,000 114,900

Note payable

$100,000 117,100

Accounts payable Unearned rent revenue

3,000

Paid-in capital

400,000

Sales

160,000

Cost of goods sold Wages expense Total

100,000 28,000 $780,100

$780,100

Consider the following adjustments on January 31: a. January depreciation expense, $1,000. b. On January 2, Chan paid $15,000 for rent in advance to cover the first quarter of 20X0, as shown by the $15,000 debit balance in the Prepaid Rent account. Adjust for the consumption of January rent. c. Wages earned by employees during January but not paid as of January 31 totaled $3,750. d. Chan borrowed $100,000 from the bank on January 1. The company recorded this explicit transaction when it borrowed the money, as shown by the $100,000 credit balance in the Note Payable account. Chan is to pay the principal and 6% interest 1 year later (January 1, 20X1). Chan has not yet made an adjustment for the recognition of January interest expense. e. On January 1, Chan made a cash loan of $40,000 to a local supplier, as shown by the $40,000 debit balance in the Note Receivable account. The promissory note stated that the loan is to be repaid 1 year later (January 1, 20X1), together with interest at 4.5% per annum. On January 31, Chan needs to make an adjustment to recognize the interest earned on the note receivable. f. On January 15, a nearby corporation paid Chan $3,000 cash as an advance rental for temporary use of Chan’s excess storage space and equipment. The rental agreement covers the 3 months from January 15 to April 15. This $3,000 is the credit balance in the Unearned Rent Revenue account. On January 31, Chan needs to make an adjustment to recognize the rent revenue earned for one-half a month. g. Chan must accrue income tax expense on January income at a rate of 40% of income before taxes.

153

154

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

Required 1. Enter the trial balance amounts in the general ledger. Set up the new asset account, Accrued Interest Receivable, and the new contra asset account, Accumulated Depreciation, Store Equipment. Set up the following new liability accounts: Accrued Wages Payable, Accrued Interest Payable, and Accrued Income Taxes Payable. Set up the following new expense and revenue accounts: Depreciation Expense, Rent Expense, Interest Expense, Interest Revenue, Rent Revenue, and Income Tax Expense. 2. Journalize adjustments (a) to (g) and post the entries to the ledger. Identify entries by transaction letter. 3. Prepare an adjusted trial balance as of January 31, 20X0.

Solution The solutions to requirements 1 through 3 are in Exhibits 4-2, 4-3, and 4-4. Accountants often refer to the final trial balance, Exhibit 4-4, as the adjusted trial balance. Why? All the necessary adjustments have been made; thus, the trial balance provides the data necessary for creating the formal financial statements. EXHIBIT 4-2 Chan Audio Company Journal Entries Debit Credit (a) Depreciation expense..................................................................... 1,000 Accumulated depreciation, store equipment .............................. 1,000 Depreciation for January (b) Rent expense ................................................................................ 5,000 Prepaid rent............................................................................ 5,000 Rent expense for January $15,000 ÷ 3 = $5,000 (c) Wages expense.............................................................................. 3,750 Accrued wages payable............................................................ 3,750 Wages earned in January but not paid (d) Interest expense............................................................................ 500 Accrued interest payable.......................................................... 500 Interest for January $100,000 × .06 × 1/12 = $500 (e) Accrued interest receivable............................................................. 150 Interest revenue...................................................................... 150 Interest earned for January $40,000 × .045 × 1/12 = $150 (f) Unearned rent revenue................................................................... 500 Rent revenue........................................................................... 500 Rent earned for January, rent per month, $3,000 ÷ 3 = $1,000; for half a month, $500 (g) Income tax expense....................................................................... 8,960 Accrued income taxes payable.................................................. 8,960 Income tax on January income .40 × (160,000 + 150 + 500 – 100,000 – 28,000 – 3,750 – 1,000 – 5,000 – 500) = 8,960

THE ADJUSTING PROCESS IN PERSPECTIVE

EXHIBIT 4-3 Chan Audio Company General Ledger Assets

Liabilities + Stockholders’ Equity

=

(Increases Left, Decreases Right)

(Decreases Left, Increases Right)

Cash Bal.

Note Payable

71,700

Bal.

Accounts Receivable Bal.

160,300

Bal.

40,000

100,000

Accounts Payable

Note Receivable Bal.

Paid-in Capital

117,100

500 Bal.

3,000

Bal.

2,500

(c)

Bal.

Bal. 3,750

Prepaid Rent Bal.

15,000 (b)

Bal.

10,000

5,000

(c) Bal.

500

114,900

8,960

Accumulated Depreciation, Store Equipment

1,000

5,000 Interest Expense

(d)

Accrued Interest Receivable (e)

31,750

Rent Expense (b)

1,000

3,750

Accrued Income Taxes Payable (g)

(a)

28,000

Depreciation Expense (a)

Bal.

100,000

Accrued Interest Payable (d)

Store Equipment

160,000

Wages Expense Accrued Wages Payable

250,200

Bal.

Cost of Goods Sold

Merchandise Inventory Bal.

400,000

Sales

Unearned Rent Revenue (f)

Bal.

500 Interest Revenue

150

(e)

150

Rent Revenue (f) Income Tax Expense (g)

8,960

500

155

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

EXHIBIT 4-4 Chan Audio Company Adjusted Trial Balance, January 31, 20X0 Account Title

Balance Debit

Cash Accounts receivable Note receivable Accrued interest receivable Merchandise inventory Prepaid rent Store equipment

Credit

$ 71,700 160,300 40,000 150 250,200 10,000 114,900

Accumulated depreciation, store equipment

$

1,000

Note payable

100,000

Accounts payable

117,100

Unearned rent revenue

2,500

Accrued wages payable

3,750 500

Accrued interest payable

8,960

Accrued income taxes payable Paid-in capital

400,000

Sales

160,000

Interest revenue

150

Rent revenue

500

Cost of goods sold Wages expense

100,000

1,000

Rent expense

5,000

Income tax expense Total

Income Statement Exhibits 4-9 and 4-10

31,750

Depreciation expense

Interest expense

Balance Sheet Exhibit 4-5

500 8,960 $794,460

$794,460

Classified Balance Sheet  OBJECT IVE 7 Prepare a classified balance sheet and use it to assess short-term liquidity.

classified balance sheet A balance sheet that groups the accounts into subcategories to help readers quickly gain a perspective on the company’s financial position and to draw attention to certain accounts or groups of accounts.

Once the company has recorded all necessary adjusting entries, it is ready to prepare the financial statements. As we saw in Chapter 1, balance sheet accounts are separated into the major categories of assets, liabilities, and owners’ equity. A classified balance sheet further groups the accounts into subcategories to help readers quickly gain a perspective on the company’s financial position and to draw attention to certain accounts or groups of accounts. Assets are frequently classified into two groups: current assets and noncurrent or long-term assets. Liabilities are similarly classified into current liabilities and noncurrent or long-term liabilities.

Current Assets and Liabilities Current assets are cash and other assets that a company expects to convert to cash, sell, or consume during the next 12 months (or within the normal operating cycle if longer than 1 year). Similarly, current liabilities are those liabilities that come due within the next year (or within the normal operating cycle if longer than a year). Typically, we expect companies to pay current

CLASSIFIED BALANCE SHEET

157

EXHIBIT 4-5 Chan Audio Company Balance Sheet, January 31, 20X0 Assets

Liabilities and Stockholders’ Equity

Current assets

Current liabilities

Cash

$ 71,700

Accounts receivable Note receivable Accrued interest receivable

Unearned rent revenue

2,500

40,000

Accrued wages payable

3,750

250,200 10,000

Prepaid rent Total current assets

532,350

Long-term assets Store equipment Accumulated depreciation Total

$117,100

160,300 150

Merchandise inventory

Accounts payable

Accrued interest payable

500

Accrued income taxes payable

8,960

Note payable

100,000

Total current liabilities

232,810

Stockholders’ equity $114,900 (1,000)

Paid-in capital 113,900 $646,250

Retained earnings

$400,000 13,440

Total

liabilities using assets classified as current. Identifying current assets and liabilities is useful in assessing the company’s ability to meet obligations as they become due. For the most part, current assets give rise to the cash needed to pay current liabilities, so the relationship between these categories is important. Exhibit 4-5 shows the classified balance sheet for Chan Audio Company, which we prepared from the adjusted trial balance for the company (shown in Exhibit 4-4). In the United States a classified balance sheet generally lists the current asset accounts in the order in which the assets are likely to be converted to cash during the coming year. Therefore, Cash appears first. In the case of Chan Audio, Accounts Receivable appears next because the firm should receive cash payments for these accounts within weeks or months. The Note Receivable and related Accrued Interest Receivable, the third and fourth accounts listed, are due January 1, 20X1, within the 1 year (or normal operating cycle) time frame for classification as current assets. Nonmonetary assets, such as inventories and prepaid expenses (in this case, Merchandise Inventory and Prepaid Rent), appear last in the current assets section of the balance sheet. Chan does not convert Prepaid Rent to cash, but it is a current asset in the sense that its existence reduces the obligation to pay cash within the next year. As shown in Exhibit 4-5, we also list current liability accounts in the approximate order in which they will require the use of cash during the coming year. Wages tend to be paid weekly or monthly, whereas interest and taxes tend to be paid monthly, quarterly, or annually. The difference between current assets and current liabilities is working capital (net working capital or net current assets). In the case of Chan Audio Company, the working capital on January 31, 20X0, is ($532,350 – $232,810) = $299,540. Working capital is important because it relates current assets and current liabilities. It normally increases in dollar amount as the company grows, so it is proportional to the size of the firm.

413,440 $646,250

current assets Cash and other assets that a company expects to convert to cash, sell, or consume during the next 12 months or within the normal operating cycle if longer than 1 year.

current liabilities Liabilities that come due within the next year or within the normal operating cycle if longer than 1 year. Typically, we expect current liabilities to be paid using assets classified as current.

working capital (net working capital, net current assets) The excess of current assets over current liabilities.

Formats of Balance Sheets While all balance sheets contain the same basic information, the details and formats of balance sheets and other financial statements vary across companies and accounting jurisdictions. For example, consider the balance sheets of Columbia Sportswear for December 31, 2010, and December 31, 2009, as shown in Exhibit 4-6. The format and classifications are those actually used by Columbia. Note the absence of a separate subtotal for noncurrent assets and noncurrent liabilities. Some companies prefer to omit these subtotals when there are only a few items within a specific class. Exhibit 4-6 presents a classified balance sheet in the report format (assets at the top), which is different from the account format (assets on the left) illustrated in Exhibit 4-5. Either format is acceptable.

report format A classified balance sheet with the assets at the top.

account format A classified balance sheet with the assets on the left.

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

EXHIBIT 4-6 Columbia Sportswear Company Consolidated Balance Sheets (in thousands) December 31 2010

2009

Assets Current assets Cash and cash equivalents

$ 234,257

$ 386,664

Short-term investments

68,812

22,759

Accounts receivable, net

300,181

226,548

Inventories, net

314,298

222,161

45,091

31,550

Deferred income taxes Prepaid expenses and other current assets Total current assets Property, plant, and equipment, net

28,241

32,030

990,880

921,712

221,813

235,440

Intangible assets, net

40,423

27,127

Goodwill

14,470

12,659

Other noncurrent assets

27,168

15,945

$1,294,754

$1,212,883

Accounts payable

$ 130,626

$ 102,494

Accrued liabilities

102,810

67,312

16,037

6,884

Total assets Liabilities and Shareholders’ Equity Current liabilities

Income taxes payable

2,153

2,597

251,626

179,287

Income taxes payable

19,698

19,830

Deferred income taxes



Deferred income taxes Total current liabilities

Other long-term liabilities Total liabilities

1,494

21,456

15,044

292,780

215,655

Shareholders’ equity: Preferred stock; 10,000 shares authorized; none issued and outstanding Common stock; (no par value) 125,000 shares authorized; 33,683 and 33,736 issued and outstanding Retained earnings Accumulated other comprehensive income Total shareholders’ equity Total liabilities and shareholders’ equity





5,052

836

950,207

952,948

46,715

43,444

1,001,974

997,228

$1,294,754

$1,212,883

Foreign companies and U.S. companies in certain industries may use formats that differ from those presented in Exhibits 4-5 and 4-6. Exhibit 4-7 shows a condensed balance sheet for Nokia Corporation, a Finnish company that is one of the world’s largest makers of cell phones. Nokia prepares a classified balance sheet in a format that is common for companies reporting under IFRS. Note that Nokia lists noncurrent assets totaling €11,978 million before current assets totaling €27,145 million. The sequencing of the liabilities and equity side of the balance sheet is reversed relative to the ordering typical in a balance sheet prepared under U.S. GAAP. Nokia first lists shareholders’ equity totaling €16,231 million, followed by noncurrent liabilities of €5,352 million and finally current liabilities of €17,540 million. Unilever Group is a dual-listed company consisting of Unilever NV headquartered in Rotterdam, Netherlands,

CLASSIFIED BALANCE SHEET

159

EXHIBIT 4-7 Nokia Corporation Condensed Consolidated Balance Sheets (in millions of euros) December 31 2010

2009

€11,978

€12,125

Assets Noncurrent assets Current assets Total assets

27,145

23,613

€39,123

€35,738

€16,231

€14,749

5,352

5,801

Shareholders’ Equity and Liabilities Total equity Noncurrent liabilities Current liabilities Total shareholders’ equity and liabilities

17,540

15,188

€39,123

€35,738

and Unilever PLC headquartered in London, England. The company operates as a single business and is the top maker of packaged consumer goods in the world. Unilever also uses IFRS to prepare its financial statements. Exhibit 4-8 shows balance sheets for Unilever for December 31, 2010, and December 31, 2009. Unilever lists noncurrent assets before current assets and then deducts current liabilities from current assets to give a direct measure of working capital (called net current assets or net current liabilities). Unilever reports negative working capital of €1,122 million as of December 31, 2010. After the calculation of a subtotal representing total assets less current liabilities, Unilever reports noncurrent liabilities and shareholders’ equity. Recognize that, regardless of the format and modest differences in account naming conventions, balance sheets contain the same basic information.

Current Ratio Current assets are an indicator, albeit an imperfect indicator, of how much cash a company will have on hand in the near future; current liabilities tell you how much debt the company will have to pay off with that cash in the near future. Comparing the two amounts helps financial statements users assess a business entity’s liquidity, which is its ability to meet its near-term financial obligations with cash and near-cash assets as those obligations become due. Investors use the current ratio (also called the working capital ratio), which we calculate by dividing current assets by current liabilities, to evaluate a company’s liquidity. Chan Audio’s current ratio is $532,350 Current ratio = = 2.29 $232,810 A current ratio that is too low may indicate the company will have difficulty meeting its short-term obligations. Conversely, a current ratio that is too high may indicate excessive holdings of current assets such as cash, accounts receivable, or inventories. Excessive holdings of this nature are bad for a company because they tie up money that could be more effectively used elsewhere. How do we assess this ratio? Is a higher current ratio always better? Other things being equal, the higher a company’s current ratio, the more assurance creditors have that the company will be able to pay them in full and on time. However, as with all ratios, it can be misleading to draw conclusions from the numeric value of the ratio alone. In the case of the current ratio, it is important to consider the composition of current assets and current liabilities before drawing inferences. Suppose that just prior to the end of January, Chan Audio used $70,000 of its cash to pay off part of the outstanding balance in Accounts Payable. The restated current ratio is Current ratio =

$532,350 - $70,000 = 2.84 $232,810 - $70,000

liquidity An entity’s ability to meet its near-term financial obligations with cash and near-cash assets as those obligations become due.

current ratio (working capital ratio) Current assets divided by current liabilities.

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

EXHIBIT 4-8 Unilever Group Condensed Consolidated Balance Sheets (in millions of euros)

Goodwill Intangible assets Property, plant, and equipment Pension asset for funded schemes in surplus Deferred tax assets Other noncurrent assets Total noncurrent assets Inventories Trade and other current receivables Current tax assets Cash and cash equivalents Other financial assets Noncurrent assets held for sale Total current assets Financial liabilities Trade payables and other current liabilities Current tax liabilities Provisions Liabilities directly associated with noncurrent assets held for sale Total current liabilities Net current assets/(liabilities) Total assets less current liabilities Financial liabilities due after one year Noncurrent tax liabilities Pensions/post-retirement health-care liabilities Funded schemes in deficit Unfunded schemes Provisions Deferred tax liabilities Other noncurrent liabilities Total noncurrent liabilities Share capital Share premium Other reserves Retained profit Shareholders’ equity Non-controlling interests Total equity Total capital employed

December 31 2010 2009 €13,178 €12,464 5,100 4,583 7,854 6,644 910 759 607 738 1,034 1,017 28,683 26,205 4,309 3,578 4,135 3,429 298 173 2,316 2,642 550 972 876 17 12,484 10,811 (2,276) (2,279) (10,226) (8,413) (639) (487) (408) (420) (57) — (13,606) (11,599) (1,122) (788) €27,561 €25,417 €7,258 184

€7,692 107

1,081 1,899 886 880 295 12,483 484 134 (5,406) 19,273 14,485 593 15,078 €27,561

1,519 1,822 729 764 248 12,881 484 131 (5,900) 17,350 12,065 471 12,536 €25,417

Even though the restated current ratio is higher than the previous value of 2.29, it is difficult to argue that Chan is more liquid as it has only $1,700 in cash. The relative liquidity of Chan under these two different scenarios depends on the company’s ability to convert its noncash current assets such as Merchandise Inventory and Accounts Receivable to cash. This illustrates one of the difficulties in interpreting the current ratio; some current assets are less liquid than others and may take longer to convert to cash.

INCOME STATEMENT

Variations of the current ratio attempt to distinguish among assets based on their relative level of liquidity. One common variation of the current ratio is the quick ratio (also known as the acid test ratio), which removes inventory (and potentially other less liquid assets such as prepaid expenses) from the numerator of the calculation. This ratio provides a more restrictive view of the company’s liquidity. For example, in the initial scenario depicted for Chan Audio, the quick ratio is [($532,350 – $250,200) ÷ $232,810] = 1.21. In the second scenario, the quick ratio is [($532,350 – $250,200 – $70,000) ÷ ($232,810 – $70,000)] = 1.30. An old rule of thumb was that the current ratio should be greater than 2.0. However, in strong economic times, when companies have good investment opportunities, current ratios are more commonly close to 1.0. And in 2011, following the very weak economies of the preceding few years, current ratios for many companies were well over 2.0. Why? Because companies were holding large amounts of cash. In making judgments about a company’s liquidity, analysts do not focus on the ratio value in isolation; rather they compare a company’s current ratio with those of past years, with those of similar companies, or with an industry norm. For example, on January 1, 2012, IBM’s ratio was 1.21, compared with an industry median of about 2.5. Although only slightly greater than 1.0 and below the industry median, IBM’s ratio is probably not a cause for concern. Over fiscal years 2006 through 2011, IBM’s current ratio ranged from a low of 1.11 at December 31, 2009, to a high of only 1.36 at December 31, 2006. This consistently low current ratio suggests that IBM is comfortable operating with current assets only slightly larger than current liabilities. It is also common for firms in the utility industry to have low current ratios because of low levels of inventory and stable cash flows. For example, Pacific Gas & Electric, a regional gas and electric power company, had a current ratio of only 0.84 on January 1, 2012. On the other hand, Google’s current ratio of 5.9 on the same day was almost five times as large as IBM’s and seven times as large as that of Pacific Gas & Electric. You will find more information on working capital and the current ratio in the Business First box on page 162. Although some people use the current or quick ratio to measure short-term debt-paying ability, a prediction of cash receipts and disbursements is more useful. Whether a company’s level of cash is too low or too high really depends on the forecasts of operating requirements over the coming months. For example, a company such as a small comic book and baseball card retailer might need very little cash on hand because upcoming debts and operating needs will be small in the next few months. Conversely, Marvel Comics, the corporation that produces the comic books sold by the small retailer, will need millions of dollars in cash to meet upcoming debt and shortterm operating needs. As a rule, companies should try to keep on hand only the cash necessary to meet disbursement needs and invest any temporary excess cash to generate additional income.

161

quick ratio (acid test ratio) Variation of the current ratio that removes less liquid assets from the numerator. Perhaps the most common version of this ratio is (current assets – inventory) ÷ current liabilities.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Published annual reports typically contain condensed balance sheet information. This level of detail is appropriate for external analysts and investors. Is this same level of detail sufficient for internal use?

Answer No. Firms prepare detailed balance sheets for their internal use. Suppose that you are the person responsible for managing inventory at Columbia Sportswear’s flagship store in Portland, Oregon.

Rather than just knowing the total amount of inventory on hand, you would need to know what the inventory levels are for spring merchandise and for summer merchandise, for men’s wear and women’s wear, and for clothing and accessories. This detail and more is necessary for you to manage your operation and evaluate your performance. Outside investors are more concerned with the overall performance of Columbia Sportswear relative to competing retailers, so summarized company-wide information is sufficient.

Income Statement We have seen that balance sheets provide decision makers with information about a company’s ability to meet its short-term operating and debt needs. However, investors are also concerned about a company’s ability to generate earnings and pay dividends. The income statement provides some of the information necessary to address these concerns. Income statements, like balance sheets, may include subcategories that help focus attention on certain accounts or groups of accounts. There are two commonly used income statement formats, the single-step income statement and the multiple-step income statement.

 OBJECTIVE 8 Prepare single- and multiplestep income statements.

BUSINESS FIRST M A N A G I N G W O R K I N G C A P I TA L The main components of working capital for a typical company are accounts receivable plus inventories less accounts payable. Analysts must interpret fluctuations in working capital levels with care. All else equal, lower levels of receivables and inventories and higher levels of accounts payable will decrease working capital levels. Receivables may decrease because of declining sales, but they can also decrease when collection of receivables speeds up. Decreasing inventories may mean decreased ability to deliver orders on time. However, they may also mean the company is doing a better job anticipating customer demand. Accounts payable may increase for a variety of reasons: increasing inventory purchases in response to higher demand, the company’s inability to meet its short-term obligations, or a conscious decision on the part of the company to effectively use supplier financing. The traditional view is that large amounts of working capital and high current ratios are good—they show that a company is likely to remain solvent. However, large amounts of working capital may needlessly tie up funds that can be used profitably elsewhere in the company. Each dollar not invested in working capital is a dollar of cash available for investing in value-adding activities—activities that actually create and deliver products or services to customers. When companies have good investment opportunities, working capital levels tend to be lower. In the 1990s, the booming economy offered such opportunities and holding large amounts of inventories and accounts receivable fell out of fashion. The stated target of some firms was zero working capital and a current ratio of 1.0, and many companies made a concerted effort to reduce working capital and, hence, lower their current ratios. The financial crisis of 2008 brought an economic slowdown and nearly frozen credit markets. Faced with declining revenues and an inability to borrow, the working capital of many U.S. companies began to creep back up. As sales levels declined, inventory levels rose and some companies faced an increase in receivables levels because customers took longer to pay. When faced with this situation, companies had to reexamine their working capital management. In an article published in CFO World, Brian Shanahan of REL Consultancy stated, “If you are looking for some kind of funding, with the exception of stealing money from someone, improving your working capital position is the cheapest way you can do it.” Consider Cytec Industries, a global supplier of specialty chemicals and materials. Despite a current ratio of 2.45 at the end of 2008, Cytec was faced with a liquidity challenge. While the current ratio was high, the company held only $55.3 million, less than 5% of current assets, in cash. Trade receivables of $448.8 million and inventories of $569.4 million comprised 37% and 47% of current assets, respectively. To ensure an adequate cash balance, the company began a concerted effort to improve its

working capital performance in 2009, including linking employee pay to the company’s working capital goals. Cytec’s current ratio decreased 19% to 1.98 at the end of 2009. This lower current ratio does not necessarily indicate a reduction in liquidity or decreased efficiency in management of working capital. In fact, the opposite is true. Cytec dramatically improved the rate at which it collected accounts receivable in 2009, reducing the balance in Trade Accounts Receivable at year-end to $374.2 million (33% of current assets). As a result of improved inventory management, Cytec also reduced its inventory levels by 38% to $351.9 million by year-end 2009, down to 31% of current assets. Less money tied up in inventory leaves more available for other uses. These actions, along with others, resulted in $261.7 million in available cash at the end of 2009, a 373% increase! Cytec’s current ratio increased to 2.26 by the end of 2010. Remember that a higher current ratio does not always indicate improved liquidity. However, in this case, Cytec continued to improve its working capital management. The cash balance increased to $383.3 million or 29% of current assets, while accounts receivable and inventories fell to 28% and 27% of current assets, respectively. The company attributed these changes to continued increases in the rate of receivables collections, increased inventory sales, and successful inventory management. Cytec is not alone in holding a large cash balance. According to a survey of U.S. finance executives done by CFO, U.S. nonfinancial companies held more than $2 trillion in cash and other liquid assets as of the end of June 2011. Due to the slow economic recovery, uncertain demand for products, and volatile world financial markets, companies continue to maintain large cash balances. Thomson Reuters, the global provider of financial, legal, tax and accounting, health-care, and scientific information, data, and news, improved its working capital management in 2010. How did Thomson Reuters accomplish this? While Cytec achieved greater liquidity by effective management of receivables and inventories, Thomson Reuters has virtually no inventory, so inventory management improvements were not possible. Also, the company does much of its business outside the United States, where longer-term receivables collection times are the norm. As a result the company focused its efforts on its payable cycle, taking better advantage of supplier credit. You can see that analysts must look beyond the current ratio value itself to gain an understanding of the actual performance of the company. Sources: K. O’Sullivan, “Sitting Comfortably on a Cash Cushion,” CFO, November 1, 2011, pp. 45–47; C. Doherty, “Working Capital Improvements,” CFO World, September 2, 2011, http://www. cfoworld.co.uk/in-depth/financial-planning/3300926/working-capital-improvements; D. Katz, “Easing the Squeeze: The 2011 Working Capital Scorecard,” CFO, July 15, 2011, pp. 44–51; Cytec Industries 2010 and 2009 Annual Reports; Thomson Reuters 2010 Annual Report.

INCOME STATEMENT

163

Single- and Multiple-Step Income Statements The adjusted trial balance for Chan Audio Company (Exhibit 4-4) provides the data for the two formats of income statements shown in Exhibits 4-9 and 4-10. Exhibit 4-9 presents a single-step income statement. Notice that it groups all types of revenue together (e.g., Sales Revenue, Rent Revenue, and Interest Revenue) and then deducts all expenses without reporting any intermediate subtotals. Exhibit 4-10 provides an example of a multiple-step income statement. Rather than grouping all revenues together and then subtracting all expenses, the multiple-step income statement combines revenues and expenses to highlight significant relationships. Regardless of the presentation format, the net income number is the same. There is no theoretical or practical reason to prefer one of these formats. Experienced readers of financial statements can easily adjust from one to another. As you begin to read and evaluate actual statements, do not let the superficial differences in presentation confuse you. EXHIBIT 4-9 Chan Audio Company Single-Step Income Statement for the Month Ended January 31, 20X0 Sales

$160,000

Rent revenue

500

Interest revenue

150

Total sales and other revenues

160,650

Expenses Cost of goods sold Wages

$100,000 31,750

Depreciation

1,000

Rent

5,000

Interest Income taxes

500 8,960

Total expenses

147,210 $ 13,440

Net income

EXHIBIT 4-10 Chan Audio Company Multiple-Step Income Statement for the Month Ended January 31, 20X0 Sales Cost of goods sold Gross profit Operating expenses Wages Depreciation Rent Operating income Other revenues and expenses Rent revenue Interest revenue Total other revenue Deduct: interest expense Income before income taxes Income taxes Net income

$160,000 100,000 60,000 $31,750 1,000 5,000

500 150 650 500

37,750 22,250

150 22,400 8,960 $ 13,440

single-step income statement An income statement that groups all revenues together and then lists and deducts all expenses without reporting any intermediate subtotals.

multiple-step income statement An income statement that contains one or more subtotals that highlight significant relationships.

164

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

EXHIBIT 4-11 Columbia Sportswear Company Consolidated Statements of Operations (in thousands) Year Ended December 31 2010 Net sales

$1,483,524 854,120

719,945

Gross profit

629,404

524,078

Selling, general, and administrative expenses

534,068

444,715

(7,991)

Income from operations Interest income, net Income before income tax Income tax expense Net income

The excess of sales revenue over the cost of the inventory that was sold.

operating expenses A group of recurring expenses that pertain to the firm’s routine, ongoing operations.

operating income (operating profit, income from operations) Gross profit less all operating expenses.

nonoperating revenues and expenses Revenues and expenses that are not directly related to the mainstream of a firm’s operations.

$1,244,023

Cost of sales

Net licensing income

gross profit (gross margin)

2009

$

(8,399)

103,327

87,762

1,564

2,088

104,891

89,850

27,854

22,829

77,037

$

67,021

The majority of U.S. companies employ the multiple-step income statement format in their external financial statements. The Columbia Sportswear income statement (which the company calls a statement of operations) in Exhibit 4-11 is a multiple-step income statement. Let’s take a closer look at the subtotals that commonly appear in a multiple-step statement. Most multiple-step income statements start with the separate computation and disclosure of gross profit (also called gross margin), which is the excess of sales revenue over the cost of the inventory that was sold. Chan reports a gross profit of $60,000 in Exhibit 4-10, and Columbia Sportswear’s 2010 income statement shows a gross profit of $629,404,000. The next section of a multiple-step income statement usually contains the operating expenses, which is a group of recurring expenses that pertain to the firm’s routine, ongoing operations. Examples of such expenses are wages, rent, depreciation, and various other operation-oriented expenses, such as telephone, heat, and advertising. We deduct these operating expenses from the gross profit to obtain operating income (also called operating profit or income from operations). Chan reports operating income of $22,250 in Exhibit 4-10. In Exhibit 4-11, Columbia Sportswear groups all recurring operating expenses together into a category called Selling, General, and Administrative Expenses and subtracts them from gross profit. Finally, prior to computing income from operations, Columbia Sportswear also deducts from operating expenses a small amount of income from licensing activities. Be sure to note that, while Columbia subtracts Selling, General, and Administrative Expenses from gross profit when computing Income from Operations, it adds the line item called Net Licensing Income to gross profit because it is a revenue item, not an expense item. Columbia reports income from operations of $103,327,000 in 2010. The next grouping in the multiple-step income statement contains nonoperating revenues and expenses, which are revenues and expenses that are not directly related to the mainstream of a firm’s operations. Nonoperating revenues are usually minor in relation to the sales revenue shown in the first section of the multiple-step statement. Nonoperating expenses are also minor, with the possible exception of interest expense. Some companies have significant levels of debt (which causes high interest expense), whereas other companies incur little debt and have low interest expense. Chan Audio Company separately itemizes Interest Expense and Interest Revenue in Exhibit 4-10. In contrast, Columbia Sportswear nets Interest Expense and Interest Revenue on the income statement. In all financial statements, accountants use the label “net” to denote that some amounts have been offset in computing the final result. Thus, if a company reports net interest, it means that interest revenue and interest expense have been combined into one number, which may result in either an expense or a revenue. In the case of Columbia Sportswear, interest revenue exceeds interest expense in both years shown in Exhibit 4-11. Note that Interest Income, Net has been added to Income from Operations to arrive at Income before Income Tax. Users of financial statements usually regard interest revenue and interest expense as “other” or “nonoperating” items because they arise from lending and borrowing

PROFITABILITY EVALUATION RATIOS

165

EXHIBIT 4-12 Unilever Group Condensed Consolidated Income Statement for the Year Ended December 31, 2011 (in millions of euros) Turnover Operating profit Net finance costs Other nonoperating income (loss) Profit before taxation Taxation Net profit

€46,467 6,433 (448) 260 6,245 (1,622) € 4,623

money—activities that are distinct from most companies’ ordinary operations of selling goods or services. Exceptions occur in companies in the business of lending and borrowing money: banks, credit unions, insurance companies, and other financial intermediaries. If income statements keep nonoperating revenues and expenses separate from operating revenues and expenses, we can easily compare operating income over time or between companies. Comparisons of operating income focus attention on selling the product and controlling the costs of doing so. Success in this arena is an important test of a company’s health. Note where income taxes appear in both the single-step and multiple-step income statements of Chan Audio in Exhibits 4-9 and 4-10, as well as in Columbia Sportswear’s income statement in Exhibit 4-11. Most companies follow the practice of showing income taxes as a separate item immediately above net income, regardless of the grouping of other items on the income statement. IFRS and U.S. GAAP are broadly similar with respect to the presentation of the income statement. The suggested income statement format for companies reporting under IFRS includes subtotals for gross profit and pretax income. This is similar, but not identical, to the U.S. multiplestep format. However, while IFRS allows companies to display expenses either by nature or by function, U.S. GAAP requires them to show expenses by function. The income statement of Nokia Corporation, the Finnish cell phone company referenced earlier in the chapter, is indistinguishable in format from the multiple-step income statement of Columbia Sportswear. However, you can see a few major format differences in a condensed version of the income statement of Unilever Group, the Anglo-Dutch consumer products giant, shown in Exhibit 4-12. The company reports Turnover of €46,467 million for the year ended December 31, 2011. The term turnover, used by some IFRS companies, is synonymous with sales or sales revenue. Unilever then reports operating profit of €6,433 million without itemizing the operating expenses. While you can deduce that operating expenses were (€46,467 million – €6,433 million) = €40,034 million, the income statement does not show them directly. The remainder of the statement is similar to those shown earlier. Analysts and investors follow trends in corporate earnings. When observing earnings trends, it is important to distinguish between trends in operating versus nonoperating activities. There is a distinction between those circumstances where earnings growth is due to declining interest expense or increasing interest revenue and those circumstances where earnings growth is due to a dramatic increase in sales. The first two sources of earnings growth are not directly linked to the company’s routine, ongoing activities. However, when demand for the product increases, the long-term potential for continued growth is improved. The need to use caution in interpreting changes in earnings is not limited to the distinction between operating and nonoperating earnings. For example, everything else equal, a reduction in research and development expense— an operating expense—will result in an improvement in current period earnings. However, the long-term implications for the company may be negative if research and development is crucial to the development of new products.

Profitability Evaluation Ratios For experienced managers, the income statement and balance sheet are key components of the “language of business.” These managers can compare current period income with that of the previous quarter or prior year. They have a solid understanding of their competitors’ financial

turnover Sales or sales revenue.

 OBJECTIVE 9 Use ratios to assess profitability.

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profitability The ability of a company to provide investors with a particular rate of return on their investment.

rate of return The return per dollar invested.

statements and can evaluate how their company compares with the competition. How can individuals who do not have this deep company and industry knowledge use the financial statements to gain insights into the company’s performance? Earlier in this chapter, we saw that ratios such as the current ratio help give meaning to the numbers in the balance sheet. Similarly, ratios using income statement numbers are useful in evaluating a company’s profitability, which is the ability of a company to provide its investors with a particular rate of return on their investment. If Mary invests $100 in Columbia Sportswear and receives $10 every year as a result, $10 is her return on investment. However, absolute amounts are hard to evaluate. What if Mary had given Columbia Sportswear $200? In that case, a return of $10 would not be as attractive. Thus, it is common to express the return as a rate of return, a return per dollar invested. In the case of a $100 investment, a $10 return is a 10% rate of return ($10 ÷ $100). For a $200 investment, a $10 return is a 5% rate of return ($10 ÷ $200). Profitability measures are useful decision-making tools. Investors use them to distinguish among different investment opportunities. Managers know that their company’s profitability measures will affect the investment decisions of investors and that high profitability makes it easier to raise capital by selling stock or issuing debt securities. From time to time, managers may have to decide whether to buy another company, a division of a company, or a machine that will be used in manufacturing a new product. In each case, the manager will evaluate the profitability of the project as part of making the decision. Investors use trends in profitability measures over time, and within and across industries, as a basis for predictions and decisions. We provide a very brief introduction to four profitability ratios: gross profit percentage, return on sales, return on common stockholders’ equity, and return on assets. Chapter 12 expands on the interpretation of these ratios and introduces additional measures of financial performance.

Gross Profit Percentage

gross profit percentage (gross margin percentage) Gross profit (sales revenue – cost of goods sold) divided by sales revenue.

A ratio based on gross profit (sales revenue minus cost of goods sold) is particularly useful to a retailer or manufacturer in choosing a pricing strategy and in judging its results. This measure, the gross profit percentage, or gross margin percentage, is defined as gross profit divided by sales revenue. Chan Audio Company’s gross profit percentage for January is (numbers from Exhibit 4-10) Gross profit percentage = Gross profit , Sales = $60,000 , $160,000 = 37.5% We can also present this relationship as follows:

Sales Cost of goods sold Gross profit

Amount

Percentage

$160,000

100.0%

100,000 $ 60,000

62.5 37.5%

Gross profit percentages vary greatly by industry. For example, software companies have high gross profit percentages (Microsoft’s was almost 78% for the year ending June 30, 2011). Why? Because most costs in the software industry are in research and development and sales and marketing, not in cost of goods sold. In contrast, retail companies have lower gross margin percentages because product costs are their main expense. For example, for the year ended August 28, 2011, the gross profit percentage for Costco was 12.6%. Other gross margin percentages fall between the extremes, such as Intel’s at 65.3% and Columbia Sportswear’s at 42.4%.

Return on Sales or Net Profit Margin return on sales ratio (profit margin ratio) Net income divided by sales.

Managers carefully follow the return on sales ratio (also known as the profit margin ratio), which shows the relationship of net income to sales revenue. This ratio gauges a company’s ability to control the level of all its expenses relative to the level of its sales.

PROFITABILITY EVALUATION RATIOS

167

As  with the gross profit percentage, the return on sales tends to vary by industry, but the range is not as great. We can compute Chan Audio’s return on sales ratio as follows using numbers from Exhibit 4-9 or 4-10: Return on sales = Net income , Sales = $13,440 , $160,000 = 8.4% Columbia Sportswear reports a return on sales ratio of 5.2% ($77,037 ÷ $1,483,524) for the year ended December 31, 2010.

Return on Common Stockholders’ Equity The return on common stockholders’ equity ratio (ROE or ROCE) also uses net income, but compares it with invested capital (as measured by average common stockholders’ equity) instead of sales. Many analysts regard this ratio as the ultimate measure of overall accomplishment from the perspective of the shareholder. Chan Audio’s common stockholders’ equity on January 1 was paid-in capital of $400,000 and on January 30 was this $400,000 plus $13,350 of retained earnings, making January’s average common stockholders’ equity $406,720. Therefore, the company’s return on common stockholders’ equity for the month of January is

return on common stockholders’ equity ratio (ROE or ROCE) Net income divided by invested capital (measured by average common stockholders’ equity).

Return on common stockholders’ equity = Net income , Average common stockholders’ equity = $13,440 , $406,720 = 3.3% (for 1 month)

Return on Assets The return on assets ratio (ROA) compares net income with invested capital as measured by average total assets. The company invests its resources in assets, which it uses to generate revenues and ultimately, net income. The return on assets ratio measures how effectively those assets generate profits. Assuming a balance in total assets of $620,000 as of January 1, we can calculate the return on assets ratio for Chan Audio for the month of January as follows: Return on assets = Net income , Average total assets = $13,440 , 1/2 (January 1 balance, $620,000 + January 31 balance, $646,250) = $13,440 , $633,125 = 2.1% (for 1 month) Other variations of the return on assets ratio are discussed in Chapter 12. Chan Audio’s 37.5% gross profit percentage is high compared with the average of 31.1% for the retail stereo industry. Chan Audio has also maintained excellent expense control as evidenced by its 8.4% return on sales, 39.6% return on common stockholders’ equity (a monthly rate of 3.3% * 12 = 39.6% as an annual rate), and 25.2% return on assets (2.1% * 12 = 25.2%), which are higher than the annual returns earned by the industry over the same period. Recent examples of annual return on sales, return on common stockholders’ equity, and return on assets ratios for firms in different industries are shown here: Return on Sales (%) Microsoft Costco McDonald’s

33.1

Return on Common Stockholders’ Equity (%) 54.0

Return on Assets (%) 28.2

1.6

12.4

5.8

20.6

34.5

15.9

CVS Caremark

3.6

9.3

5.5

Honda (Japan)

6.3

12.5

4.9

29.0

20.7

17.3

Delta Air Lines

Google

1.9

103.9

1.6

Starbucks

8.8

28.1

15.8

return on assets ratio (ROA) Net income divided by average total assets.

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The return on stockholder’s equity for Delta Air Lines may seem out of line, especially with its small returns on sales and assets. It is a result of very small stockholders’ equity. This is an illustration that ratios can be distorted by extremely small denominators.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Which industry would you expect to have a higher gross margin percentage, the grocery industry or the pharmaceutical industry? Why?

Answer There are many “right ways” to think about this issue. Whole Foods, a premium grocery store chain, has a gross margin of 35%, while Safeway’s is 27%. The grocery industry is a retail activity where stores buy and resell items very quickly. As a result they can accept fairly low margins because they hold the inventory briefly and face little risk of failure. In contrast, the pharmaceutical industry has to

develop drugs, seek government approval to market them, and then aggressively sell them. Thus, the pharmaceutical industry has high gross margin percentages. In 2010, Pfizer had a gross margin percentage of 76%. It is important to remember that Cost of Goods Sold excludes Selling, General, and Administrative Costs, which are larger relative to sales in the pharmaceutical industry than in the grocery industry. In addition, the pharmaceutical industry faces huge R&D costs, which accountants treat as a period cost instead of a product cost. So R&D, which may be 15% or more of sales in the pharmaceutical industry, is not part of Cost of Goods Sold and does not affect the gross margin percentage.

Summary Problem for Your Review PROBLEM Johnson & Johnson (maker of Tylenol, Band-Aid products, and other health-care and personal use products) reports a statement of earnings as follows: Johnson & Johnson Statement of Earnings for the Year Ended December 31, 2010 ($ in millions except per share figures) Sales to customers

$ 61,587 18,792

Cost of products sold Gross profit

42,795

Selling, marketing, and administrative expenses

19,424

Research and development expense

6,844

Interest income

(107)

Interest expense

455

Other (income) expense, net

(768) 25,848

Earnings before provision for taxes on income

16,947 3,613

Provision for taxes on income Net earnings

$ 13,334

Basic net earnings per share

$

4.85

1. Is this a single- or multiple-step income statement? Explain your answer. 2. What term would Columbia Sportswear use as a label for the line in Johnson & Johnson’s statements having the $16,947 figure? (Refer to the Columbia Sportswear income statement in Exhibit 4-11 on page 164.) 3. Suggest an alternative term for Interest Income. 4. What is the amount of the famous “bottom line” that is so often referred to by managers? 5. Net earnings per share are defined as net earnings divided by the average number of common shares outstanding. Compute the average number of common shares outstanding during the year.

HIGHLIGHTS TO REMEMBER

SOLUTION 1. As is often the case, Johnson & Johnson uses a hybrid of single- and multiple-step income statements. However, this one is closer to a multiple-step statement. A pure single-step statement would place Interest Income and Other Income with Sales to Customers to obtain total revenues and would not calculate a gross profit subtotal. A pure multiple-step statement would separate operating and nonoperating activities and provide a subtotal for income from operations. 2. Columbia Sportswear would use “income before income tax” to describe the $16,947 figure. 3. Interest Revenue. 4. The “bottom line” is net earnings of $13,334 million. The bottom line per average common share outstanding is $4.85. 5. Companies must show net earnings per share on the face of the income statement. Earnings per share (EPS) = Net earnings , Average number of common shares outstanding $4.85 = $13,334,000,000 , Average common shares outstanding Average shares = $13,334,000,000 , $4.85 Average shares = 2,749,278,351

Highlights to Remember

1

Understand the role of adjustments in accrual accounting. At the end of each accounting period, accountants must make adjustments so financial statements recognize revenues and expenses that do not result from explicit transactions. Make adjustments for the expiration or consumption of unexpired costs. We record many costs initially as assets and recognize them as expenses as time passes. Examples are depreciation and the consumption of prepaid rent. Make adjustments for the earning of revenues received in advance. Some companies receive payments for revenue before they earn the revenue. They initially recognize unearned revenue as a liability. As the revenue is earned, the company must reduce the liability and recognize the revenue. Examples are rental payments received in advance or payment for magazine subscriptions received in advance. To clarify these first two types of adjustments, you might view them as mirror images by looking at both sides of the adjustment simultaneously. For example, (a) the expiration of unexpired costs (the tenant’s rent expense) is accompanied by (b) the earning of unearned revenues (the landlord’s rent revenue). Make adjustments for the accrual of unrecorded expenses. Companies may incur expenses before cash disbursements are made. Such expenses should be included in the income statement of the period when they are incurred, not in the period when they are paid. Examples are the accrual of wages or interest expense. Make adjustments for the accrual of unrecorded revenues. Some revenues accrue before there is an explicit transaction. Interest revenue may be recorded before there is a legal obligation for receipt of payment. Similarly, utilities often provide services before a bill is issued. This results in the recognition of revenue and a receivable before the billing cycle sends out a request for payment. You can also view these final two types of adjustments as mirror images. For example, (a) the accrual of unrecorded expenses (a borrower’s interest expense) is accompanied by (b) the accrual of unrecorded revenues (a lender’s interest revenue). Describe the sequence of steps in the recording process and relate cash flows to adjusting entries. The adjusting entries capture expense and revenue elements that either precede or follow the related cash flows. Entries for the expiration or consumption of unexpired costs and the earning of unearned revenues follow the cash flows, whereas entries for the accrual of unrecorded expenses and the accrual of unrecorded revenues precede the cash flows. The adjusting entries provide a mechanism for capturing implicit transactions that do not necessarily generate documents that lead to them being recorded. Prepare a classified balance sheet and use it to assess short-term liquidity. Classified balance sheets divide accounts into subcategories. Assets and liabilities are separated into

2 3

4 5 6 7

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current and long-term subcategories that are useful in analysis. For example, the difference between current assets and current liabilities is called working capital. The current ratio, defined as current assets divided by current liabilities, is used to help assess liquidity. The quick or acid test ratio, frequently computed as current assets minus inventory divided by current liabilities, is also useful. Prepare single- and multiple-step income statements. Income statements may appear in single- or multiple-step format. Single-step statements group all revenue items together and all expense items together, whereas multiple-step statements calculate various subtotals such as gross profit and operating income. Regardless of the format, published income statements are highly condensed and summarized compared with reports used within an organization. Use ratios to assess profitability. Analysts use ratios based at least partly on the income statement to assess profitability. Among the most useful are gross margin percentage (or gross profit percentage), return on sales, return on common stockholders’ equity, and return on assets.

8 9

Accounting Vocabulary account format, p. 157 accrue, p. 142 acid test ratio, p. 161 adjusting entries, p. 142 adjustments, p. 142 classified balance sheet, p. 156 conservatism, p. 150 current assets, p. 156 current liabilities, p. 156 current ratio, p. 159 deferred revenue, p. 144 earnings before income tax, p. 149 explicit transactions, p. 142 gross margin, p. 164 gross margin percentage, p. 166 gross profit, p. 164

gross profit percentage, p. 166 implicit transactions, p. 142 income before income tax, p. 149 income from operations, p. 164 liquidity, p. 159 multiple-step income statement, p. 163 net current assets, p. 157 net working capital, p. 157 nonoperating revenues and expenses, p. 164 operating expenses, p. 164 operating income, p. 164 operating profit, p. 164 pretax income, p. 149 profit margin ratio, p. 166

profitability, p. 166 quick ratio, p. 161 rate of return, p. 166 report format, p. 157 return on assets ratio (ROA), p. 167 return on common stockholders’ equity ratio (ROE, ROCE), p. 167 return on sales ratio, p. 166 revenue received in advance, p. 144 single-step income statement, p. 163 turnover, p. 165 unearned revenue, p. 144 working capital, p. 157 working capital ratio, p. 159

Assignment Material Questions 4-1 Give two examples of explicit transactions. 4-2 Give two examples of implicit transactions. 4-3 Give two synonyms for unearned revenue. 4-4 Distinguish between the accrual of wages and the payment of wages. 4-5 Give a synonym for income tax expense. 4-6 Explain why income tax expense is usually the final deduction on both single-step and multiple-step income statements. 4-7 “The accrual of previously unrecorded revenues is the mirror image of the accrual of previously unrecorded expenses.” Explain by using an illustration.

4-8 What types of adjusting entries are made prior to the related cash flows? After the related cash flows? 4-9 Why are current assets and current liabilities grouped separately from long-term assets and long-term liabilities? 4-10 “Google is much more profitable than Amazon.com because its current ratio is nine times larger than Amazon’s.” Do you agree? Explain. 4-11 “Companies should always strive to avoid negative working capital.” Do you agree? Explain. 4-12 Explain the difference between a singlestep and a multiple-step income statement.

ASSIGNMENT MATERIAL

4-13 Why does interest expense typically appear below operating income on a multiplestep income statement? 4-14 The term “costs and expenses” is sometimes found instead of just “expenses” on the income statement. Would expenses be an adequate description? Why?

171

4-15 Name four popular ratios for measuring profitability, and indicate how to compute each of the four. 4-16 “Computer software companies are generally more profitable than grocery stores because their gross profit percentages are usually at least twice as large.” Do you agree? Explain.

Critical Thinking Questions 4-17 Accounting Errors You have discovered an error in which the tenant has “incorrectly” recorded as rent expense a $5,000 payment made on December 1 for rent for the months of December and January. As a young auditor you are not sure whether this must be corrected. You think it is a self-correcting error. What are the issues you should consider? 4-18 What Constitutes Revenue? You have just started a program of selling gift certificates at your store. In the first month, you sold $7,000 worth and customers redeemed $2,300 of these certificates for merchandise. Your average gross profit percentage is 38%. What should you report as gift certificate revenue, and how much gross margin related to the gift certificates will appear in the income statement?

 OBJECTIVE 2

 OBJECTIVE 3

4-19 Operating Versus Nonoperating Expenses You have recently begun a new job as an internal auditor for a large retail clothing chain. The company prepares a multiple-step income statement. You discover that a material amount of salaries expense was erroneously classified as a nonoperating expense. One of your co-workers argues that the error need not be corrected because the net income number is not affected by the misclassification. You disagree. Defend your position.

 OBJECTIVE 8

4-20 Accounting for Supplies A company began business on July 1 and purchased $2,000 in supplies including paper, pens, paper clips, and so on. On December 31, as financial statements were being prepared, the accounting clerk asked how to treat the $2,000 that appeared in the Supplies Inventory account. What should the clerk do?

 OBJECTIVE 2

Exercises 4-21 True or False Use T or F to indicate whether each of the following statements is true or false:

 OBJECTIVES 2, 3

1. 2. 3. 4.

Retained Earnings should be accounted for as a noncurrent liability. Deferred Revenue will appear on the income statement. Machinery used in the business should be recorded as a noncurrent asset. A company that employs cash-basis accounting cannot have a Prepaid Expense account on the balance sheet. 5. From a single balance sheet, you can find stockholders’ equity for a period of time but not for a specific day. 6. It is not possible to determine changes in the financial condition of a business from a single balance sheet. 4-22 Tenant and Landlord The Klassen Company, a retail hardware store, pays quarterly rent on its store at the beginning of each quarter. The rent per quarter is $24,000. The owner of the building in which the store is located is the Resing Corporation.

 OBJECTIVES 2, 3

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

Using the balance sheet equation format (refer to page 144 for an example), analyze the effects of the following on the tenant’s and the landlord’s financial position: 1. 2. 3. 4.

 OBJECT IVES 2, 3

 OBJECT IVE 4

Klassen pays $24,000 rent on July 1. Adjustment for July. Adjustment for August. Adjustment for September. Also prepare the journal entries for Klassen and Resing for September.

4-23 Customer and Airline Kimberly Clark (KC), maker of Scott paper products, decided to hold a managers’ meeting in Hawaii in February. To take advantage of special fares, KC purchased airline tickets in advance from Alaska Airlines at a total cost of $65,000. These were acquired on December 1 for cash. Using the balance sheet equation format (refer to page 144 for an example), analyze the impact of the December payment and the February travel on the financial position of both KC and Alaska. Also prepare journal entries for February for both companies. 4-24 Accrual of Wages Consider the following calendar:

S M

September T W T F

6 13 20 27

1 8 15 22 29

7 14 21 28

2 9 16 23 30

3 10 17 24

4 11 18 25

S 5 12 19 26

Miller’s Department Store commenced business on September 1. It is open every day except Sunday. Its total payroll for all employees is $6,000 per day. Payments are made each Tuesday for the preceding week’s work through Saturday. Using the balance sheet equation format (refer to page 147 for an example), analyze the financial impact on Miller’s of the following: 1. Disbursements for wages on September 8, 15, 22, and 29. 2. Adjustment for wages on September 30. Also prepare the journal entry required on September 30.

 OBJECT IVE 4

4-25 Accrued Vacation Pay As of December 31, 2008, Delta Air Lines had the following account listed as a current liability on its balance sheet: Accrued salaries and related benefits

$1,367,000,000

The “related benefits” include the liability for vacation pay. Under the accrual basis of accounting, vacation pay is ordinarily accrued throughout the year as workers perform service and earn vacation. For example, suppose a Delta baggage handler earns $1,350 per week for 50 weeks and also gets paid $2,700 for 2 weeks’ vacation each year. Accrual accounting requires that the obligation for the $2,700 be recognized as it is earned instead of when the payment is disbursed. Thus, in each of the 50 work weeks, Delta would recognize a wage expense (or vacation pay expense) of ($2,700 ÷ 50) = $54. 1. Prepare Delta’s weekly adjusting journal entry called for by the $54 example. 2. Prepare the entry for the $2,700 payment of vacation pay.

173

ASSIGNMENT MATERIAL

 OBJECTIVE 8

4-26 Placement of Interest in Income Statement Two companies have the following balance sheets as of December 31, 20X8: Sunriver Company Cash

$ 75,000 Note payable*

$125,000

150,000 Stockholders’ equity

Other assets Total

100,000

$225,000 Total

$225,000

$ 75,000 Stockholders’ equity

$225,000

*6% annual interest. Black Butte Company Cash

150,000

Other assets

$225,000

Total

In 20X9, each company had sales of $700,000 and operating expenses of $600,000. Sunriver had not repaid the $125,000 Note Payable as of December 31, 20X9. Neither company incurred any new interest-bearing debt in 20X9. Ignore income taxes. Did the two companies earn the same net income and the same operating income? Explain, showing computations of operating income and net income.

 OBJECTIVES 4, 5

4-27 Effects of Interest on Lenders and Borrowers Bank of America loaned Miller Paint Company $1,500,000 on May 1, 20X0. The loan plus interest of 4% is payable on May 1, 20X1. 1. Using the balance sheet equation format (refer to page 149 for an example), prepare an analysis of the impact of the transaction on both Bank of America’s and Miller’s financial position on May 1, 20X0. Show the summary adjustments on December 31, 20X0, for the period May 1 to December 31. Prepare an analysis of the transaction that takes place on May 1, 20X1, when Miller repays its obligation. 2. Prepare adjusting journal entries for Bank of America and Miller on December 31, 20X0. 3. Prepare the entries that Bank of America and Miller would make on May 1, 20X1 when the loan and interest is repaid. These entries should include interest that accumulates between January 1, 20X1, and May 1, 20X1.

 OBJECTIVE 1

4-28 Identification of Transactions Valenzuela Corporation’s financial position is represented by the nine balances shown on the first line of the following schedule ($ in thousands). Assume that a single transaction took place for each of the following lines, and describe what you think happened, using one short sentence for each line.

Cash

Accounts Receivable

Inventory

Bal.

$19

$32

$54

(1)

29

32

(2)

29

32

(3)

29

(4A) (4B)

Equipment

Accounts Payable

Accrued Wages Unearned Payable Rent Revenue

Paid-in Capital

Retained Earnings

$0

$29

$0

$0

$55

$21

54

0

29

0

0

65

21

54

20

29

0

0

85

21

32

66

20

41

0

0

85

21

29

47

66

20

41

0

0

85

36

29

47

58

20

41

0

0

85

28

(5)

34

42

58

20

41

0

0

85

28

(6)

14

42

58

20

21

0

0

85

28

(7)

19

42

58

20

21

0

5

85

28

(8)

19

42

58

20

21

2

5

85

26

(9)

19

42

58

19

21

2

5

85

25

(10)

19

42

58

19

21

2

3

85

27

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

 OBJECTIVES 2,3,4,5 Following is a list of effects of accounting transactions on the balance sheet equation: Assets = 4-29 Effects on Balance Sheet Equation Liabilities + Stockholders’ equity. a. b. c. d. e. f. g. h. i. j.

Increase in assets, decrease in liabilities Increase in assets, increase in liabilities Decrease in assets, decrease in stockholders’ equity Decrease in assets, decrease in liabilities Increase in assets, decrease in assets Increase in liabilities, decrease in stockholders’ equity Decrease in assets, increase in liabilities Decrease in liabilities, increase in stockholders’ equity Increase in assets, increase in stockholders’ equity None of these

Required Which of the relationships previously identified by letter defines the accounting effect of each of the following transactions? 1. 2. 3. 4. 5. 6.

The adjusting entry to recognize periodic depreciation. The adjusting entry to record Accrued Salaries. The adjusting entry to record Accrued Interest Receivable. The collection of interest previously accrued. The settlement of an Account Payable by the issuance of a Note Payable. The recognition of an expense that had been paid for previously. A “prepaid” account was increased on payment. 7. The earning of revenue previously collected. Unearned Revenue was increased when collection was made in advance.

 OBJECTIVES 2,3,4,5

4-30 Effects of Errors in Adjustments What will be the effect—understated (U), overstated (O), or no effect (N)—on the income of the present and future periods if the following errors were made? In all cases, assume that amounts carried over into 20X1 would affect 20X1 operations via the routine accounting entries of 20X1. Period 20X0 1. Revenue has been collected in advance, but earned amounts have not been recognized at the end of 20X0. Instead, all revenue was recognized as earned in 20X1. 2. Revenue for services rendered has been earned, but the unbilled amounts have not been recognized at the end of 20X0. 3. Accrued wages payable have not been recognized at the end of 20X0. 4. Prepaid rent has been paid (in late 20X0), but no adjustment for rent used in 20X0 was made. The payments have been debited to prepaid rent. They were transferred to expense in mid-20X1.

 OBJECTIVES 2,3,4,5

4-31 Effects of Adjustments and Corrections Listed here are a series of accounts that are numbered for identification. 1. Cash 2. Accounts Receivable 8. Prepaid Rent 3. Notes Receivable 9. Prepaid Insurance 4. Inventory 10. Prepaid Repairs and Maintenance 5. Accrued Interest Receivable 11. Land 6. Accrued Rent Receivable 12. Buildings 7. Fuel on Hand 13. Machinery and Equipment

20X1

ASSIGNMENT MATERIAL

14. Long-Term Debt 15. Notes Payable 16. Accrued Wages and Salaries Payable 17. Accrued Interest Payable 18. Unearned Subscription Revenue 19. Capital Stock 20. Sales 21. Fuel Expense

22. Salaries and Wages 23. Insurance Expense 24. Repairs and Maintenance Expense 25. Rent Expense 26. Rent Revenue 27. Subscription Revenue 28. Interest Revenue 29. Interest Expense

Required All accounts needed to answer this question are listed previously. The same account may be used in several answers. Prepare any necessary adjusting or correcting entries called for by the following situations, which were discovered at the end of the calendar year. With respect to each situation, assume that no entries have been made concerning the situation other than those specifically described (i.e., no monthly adjustments have been made during the year). Consider each situation separately. These transactions were not necessarily conducted by one firm. Amounts are in thousands of dollars. a. A $10,000 purchase of equipment on December 30 was erroneously debited to Long-Term Debt. The credit was correctly made to Cash. b. A business made several purchases of fuel oil. Some purchases ($900) were debited to Fuel Expense, whereas others ($1,100) were charged to an asset account. An oil gauge revealed $400 of fuel on hand at the end of the year. There was no fuel on hand at the beginning of the year. What adjustment was necessary on December 31? c. On April 1, a business took out a fire insurance policy. The policy was for 2 years, and the full premium of $3,600 was paid on April 1. The payment was debited to Insurance Expense on April 1. What adjustment was necessary on December 31? d. On December 1, $6,000 was paid in advance to the landlord for 5 months’ rent. The tenant debited Prepaid Rent for $6,000 on December 1. What adjustment is necessary on December 31 on the tenant’s books? e. Machinery is repaired and maintained by an outside maintenance company on an annual fee basis, payable in advance. The $1,800 fee for the year beginning September 1 was paid on September 1 and charged to Repairs and Maintenance Expense. What adjustment is necessary on December 31? f. On November 16, $800 of machinery was purchased, $200 cash was paid down, and a 90-day, 5% note payable was signed for the balance. The November 16 transaction was properly recorded. Prepare the adjustment for the interest on December 31. g. A publisher sells subscriptions to magazines. Customers pay in advance. Receipts are originally credited to Unearned Subscription Revenue. On June 1, $24,000 in 1-year subscriptions (all beginning on June 1) were collected and recorded. What adjustment was necessary on December 31? h. On December 30, certain merchandise inventory was purchased for $1,300 on open account. The bookkeeper debited Machinery and Equipment and credited Accounts Payable for $1,300. Prepare a correcting entry. i. A 120-day, 8%, $15,000 cash loan was made to a customer on November 1. The November 1 transaction was recorded correctly. What adjustment is necessary on December 31? 4-32 Working Capital and Current Ratio Using the Columbia Sportswear balance sheet in Exhibit 4-6 on page 158, compute Columbia’s working capital, current ratio, and quick ratio for 2010. Compute the quick ratio as (current assets – inventories) ÷ current liabilities.

 OBJECTIVE 7

4-33 Profitability Ratios The Nestlé Group, the Swiss chocolate company, sells many other food items in addition to various types of chocolates. Sales in 2011 were CHF83,642 million (where CHF means Swiss francs), cost of goods sold was CHF44,127 million, net income was CHF9,487 million, average common stockholders’ equity was CHF60,436 million, and average total assets were CHF112,866 million.

 OBJECTIVE 9

175

176

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

Compute Nestlé’s gross profit percentage, return on sales, return on average common stockholders’ equity, and return on average total assets.

 OBJECT IVES 1, 7, 9

4-34 Impact of Adjusting Entries on Ratios Exercise 4-31 asked you to write adjusting/correcting entries for transactions (a) through (i). In this problem, consider the effect on the current ratio and return on sales if the adjusting/correcting entries were not made. Indicate whether the failure to record the adjusting/correcting entry will result in these ratios being understated (U), overstated (O), or no effect (N). If additional information is necessary before you can provide the correct response, indicate with (I). Prior to the adjusting entry, the current ratio exceeds 1.0 and the company operated at a profit. Current Ratio

Return on Sales

(a) (b) (c) (d) (e) (f) (g) (h) (i)

Problems  OBJECTIVES 2,3,4,5 (Alternates are 4-37 through 4-39.) Susan Hatfield, certified public accountant, had the following 4-35 Adjusting Entries

transactions (among others) during 20X0: 1. For accurate measurement of performance and position, Hatfield uses the accrual basis of accounting. On August 1, she acquired office supplies for $3,000. Office Supplies Inventory was increased, and Cash was decreased by $3,000 on Hatfield’s books. On December 31, her inventory of office supplies was $1,300. 2. On August 1, a client gave Hatfield a retainer fee of $48,000 cash for monthly services to be rendered over the following 12 months. Hatfield increased Cash and Unearned Fee Revenue. 3. Hatfield accepted an $8,000 note receivable from a client on October 1 for tax services. The note plus interest of 6% per year was due in 6 months. Hatfield increased Note Receivable and Fee Revenue by $8,000 on October 1. 4. As of December 31, Hatfield had not recorded $800 of unpaid wages earned by her secretary during late December. For the year ended December 31, 20X0, prepare all adjustments called for by the preceding transactions. Assume that appropriate entries were routinely made for the explicit transactions described earlier. However, no adjustments have been made before December 31. For each adjustment, prepare an analysis in the same format used when the adjustment process was explained in the chapter (i.e., the balance sheet equation format). Also prepare the adjusting journal entry.

 OBJECT IVE 8

4-36 Multiple-Step Income Statement (Alternates are 4-40 and 4-51.) From the following data, prepare a multiple-step income statement for the Huffman Company for the fiscal year ended May 31, 20X0 ($ in thousands except for percentage). Sales Interest expense Utilities expense Interest revenue Income tax rate

$2,800 138 110 28 40%

Cost of goods sold Depreciation expense Rent revenue Wage expense

$1,800 160 80 400

ASSIGNMENT MATERIAL

4-37 Four Major Adjustments (Alternates are 4-35, 4-38, and 4-39.) Leslie Baker, an attorney, had the following transactions (among others) during 20X0, her initial year in law practice:

177

 OBJECTIVES 2,3,4,5

a. On July 1, Baker leased office space for 1 year. The landlord (lessor) insisted on full payment in advance. Prepaid Rent was increased and Cash was decreased by $24,000 on Baker’s books. Similarly, the landlord increased Cash and increased Unearned Rent Revenue. b. On September 1, Baker received a retainer of $12,000 cash for services to be rendered to her client, a local trucking company, over the succeeding 12 months. Baker increased Cash and Unearned Fee Revenue. The trucking company increased Prepaid Expenses and decreased Cash. c. As of December 31, Baker had not recorded $500 of unpaid wages earned by her secretary during late December. d. During November and December, Baker rendered services to another client, a utility company. She had intended to bill the company for $5,400 services through December 31, but failed to do so. Required 1. For the year ended December 31, 20X0, prepare all adjustments called for by the preceding transactions. Assume that appropriate entries were routinely made for the explicit transactions. However, no adjustments have been made before December 31. For each adjustment, prepare an analysis in the same format used when the adjustment process was explained in the chapter (i.e., the balance sheet equation format). Prepare two adjustments for each transaction, one for Baker and one for the other party to the transaction. In part (c), assume that the secretary uses the accrual basis for her entity. 2. For each transaction, prepare the journal entries for Leslie Baker and the other entities involved. 4-38 Four Major Adjustments (Alternates are 4-35, 4-37, and 4-39.) Columbia Sportswear included the following items in its December 31, 2011, balance sheet ($ in thousands): Prepaid expenses and other current assets Income taxes payable (a current liability)

 OBJECTIVES 2,3,4,5

$36,392 12,579

1. Analyze the impact of the following assumed transactions on the financial position of Columbia as of January 31, 2012. Prepare your analysis in the same format used when the adjustment process was explained in the chapter. Also show adjusting journal entries. a. On January 31, an adjustment of $728 thousand was made for the rental of various retail outlets that had originally increased Prepaid Expenses but had expired. b. During December 2011, Columbia sold product for $1,019 thousand cash to Dick’s Sporting Goods, but delivery was not made until January 28, 2012. Unearned Revenue had been increased in December. No other adjustments had been made since then. Prepare the adjustment on January 31. c. Columbia had loaned cash to several of its independent retail distributors. As of January 31, 2012, the distributors owed $112 thousand of interest that had been unrecorded. d. On January 31, Columbia increased its accrual of federal income taxes by $938 thousand. 2. Compute the ending balances on January 31, 2012, in Prepaid Expenses and in Income Taxes Payable. 4-39 Four Major Adjustments (Alternates are 4-35, 4-37, and 4-38.) Alaska Airlines showed the following items in its balance sheet as of December 31, 2011, the end of the fiscal year ($ in millions): Inventories and supplies Prepaid expenses and other current assets Air traffic liability Accrued wages, vacation, and payroll taxes

$ 44.3 93.0 489.4 163.8

 OBJECTIVES 2,3,4,5

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CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

A footnote stated, “Passenger revenue is recognized when the passenger travels. Tickets sold but not yet used are reported as air traffic liability.” The 2011 income statement included the following ($ in millions): Passenger revenues Wages and benefits expense

$3,950.7 990.5

1. Analyze the impact of the following assumed 2012 transactions on the financial position of Alaska. Prepare your analysis in the same format used when the adjustment process was explained in the chapter. Also show adjusting journal entries. a. Rented sales offices for 1 year, beginning September 1, 2012, for $9 million cash. b. On December 31, 2012, an adjustment was made for the rent in requirement (a). c. Sold 20 charter flights to Apple Computer for $250,000 each. Cash of $5 million was received in advance on November 20, 2012. The flights were for transporting marketing personnel to business conventions. d. As the financial statements were being prepared on December 31, 2012, accountants for both Alaska and Apple Computer independently noted that the first 6 charter flights had occurred in December. The rest will occur in early 2013. An adjustment was made on December 31. e. Alaska loaned $30 million to Boeing. Interest of $1.8 million was accrued on December 31. f. Additional wages of $35 million were accrued on December 31. 2. At year-end, before the adjustments for the transactions described in parts (c) and (d) of number 1, the company had $378 million in the Air Traffic Liability account related to collections in advance for flights scheduled in 2013. Compute the proper year-end balance in the Air Traffic Liability account as of December 31, 2012.

 OBJECT IVES 8, 9

4-40 Gap Inc. Financial Statements (Alternates are 4-36 and 4-51.) Gap Inc. is a specialty retailer of clothing, accessories, and personal care products for men, women, children, and babies. Products are sold under Gap, Old Navy, Banana Republic, Piperlime, and Athleta brands. Actual financial data and nomenclature from its January 29, 2011, annual report are given next ($ in millions): Net sales Gross profit Operating income Operating expenses Cost of goods sold Interest income

$14,664 5,889 1,968 ? ? 14

Earnings before income taxes Income taxes Retained earnings Beginning of year End of year Dividends declared Net earnings

$

? 778

10,815 ? 252 ?

1. Compute the missing values. Prepare a multiple-step statement of income for the year ended January 29, 2011. 2. Compute the ending balance in Retained Earnings as of January 29, 2011. 3. Compute the percentage of gross profit on sales and the percentage of net earnings on sales. 4. The average common stockholders’ equity for the year was $4,485.5 million. What was the return on average common stockholders’ equity?

 OBJECTIVES 3, 5

4-41 Accounting for Dues (Alternate is 4-42.) The Sunset Beach Golf Club provided the following data from its comparative balance sheets: December 31

Dues receivable Unearned dues revenue

20X1

20X0

$95,000 —

$75,000 $20,000

ASSIGNMENT MATERIAL

179

The income statement for 20X1, which was prepared on the accrual basis, showed Dues Revenue Earned of $590,000. No dues were collected in advance during 20X1. Prepare the 20X1 journal entries and post to T-accounts for the following: 1. Earning of dues collected in advance. 2. Billing of dues revenue during 20X1. 3. Collection of dues receivable in 20X1. 4-42 Accounting for Subscriptions (Alternate is 4-41.) A French magazine company collects subscriptions in advance of delivery of its magazines. However, many magazines are delivered to magazine distributors (for newsstand sales), and these distributors are billed and pay later. The subscription revenue earned for the month of March on the accrual basis was €200,000 (€ refers to the euro). Other pertinent data were as follows:

 OBJECTIVES 3, 5

March

Unearned subscription revenue Accounts receivable

31

1

€190,000 7,000

€140,000 9,000

Prepare journal entries and post to T-accounts for the following: 1. Collections of Unearned Subscription Revenue of €140,000 prior to March 1. 2. Billing of Accounts Receivable (a) of €9,000 prior to March 1, and (b) of €80,000 during March (credit Revenue Earned). 3. Collections of cash during March and any other entries that are indicated by the given data. 4-43 Financial Statements and Adjustments Rockwell Wholesalers, Inc. has just completed its fourth year of business in 20X1. A set of financial statements was prepared by the principal stockholder’s eldest child, a college student who is beginning the third week of an accounting course. Following is a list (in no systematic order) of the items appearing in the student’s balance sheet, income statement, and the retained earnings column of the statement of stockholders’ equity: Accounts receivable Note receivable Merchandise inventory Cash Paid-in capital Building Accumulated depreciation, building

$183,100 36,000 201,900 99,300 620,000 300,000 20,000

Advertising expense Cost of goods sold Unearned rent revenue Insurance expense Unexpired insurance Accounts payable Interest expense Telephone expense

$ 97,300 590,000 4,800 3,500 2,300 52,500 500 20,000

Land Sales Salary expense

169,200 936,800 124,300

Notes payable Miscellaneous expense

3,400

Retained earnings, December 31, 20X0

164,000

Maintenance expense

4,800

Net income

2,500 58,626

Assume that the statements in which these items appear are current and complete, except for the following matters not taken into consideration by the student: a. Salaries of $8,500 have been earned by employees for the last half of December 20X1. Payment by the company will be made on the next payday, January 2, 20X2. b. Interest at 6% per annum on the Note Receivable has accrued for 2 months and is expected to be collected by the company when the Note is due on January 31, 20X2.

 OBJECTIVES 7, 8

180

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

c. Part of the building owned by the company was rented to a tenant on November 1, 20X1, for 6 months, payable in advance. This rent was collected in cash and is represented by the item labeled Unearned Rent Revenue. d. Depreciation on the building for 20X1 is $6,250. e. Cash dividends of $60,000 were declared in December 20X1, payable in January 20X2. f. Income tax at 40% applies to 20X1, all of which is to be paid in the early part of 20X2. Required Prepare the following corrected financial statements, showing appropriate support for the dollar amounts you compute: 1. Multiple-step income statement for the year ended December 31, 20X1 2. The retained earnings column of the statement of stockholders’ equity for the year ended December 31, 20X1 3. Classified balance sheet at December 31, 20X1

 OBJECT IVES 2, 4, 5

 OBJECTIVES 2,3,4,5

4-44 Mirror Side of Adjustments Problem 4-35 described some adjustments made by Susan Hatfield, CPA. Prepare the necessary adjustment as it would be made by the client in transactions (2) and (3), and by the secretary in transaction (4). For our purposes, assume that the secretary keeps personal books on the accrual basis. 4-45 Mirror Side of Adjustments Problem 4-38 described some adjustments made by Columbia Sportswear. The adjustments are lettered (a) through (d). Prepare the necessary adjustment as it would be made by (a) landlords, (b) Dick’s Sporting Goods, (c) retail distributors, and (d) the government taxing authorities. Assume that all use accrual accounting.

 OBJECTIVES 2,3,4,5

4-46 Mirror Side of Adjustments Problem 4-39 described some adjustments made by Alaska Airlines. The adjustments are lettered (a) through (f). Repeat the requirements for each adjustment as it would be made by the other party in the transaction: specifically, (a) and (b) landlord, (c) and (d) Apple Computer, (e) Boeing, and (f) employees. Assume that all use accrual accounting.

 OBJECTIVES 2, 4

4-47 Journal Entries and Posting Nike is a worldwide leader in the design, marketing, and distribution of athletic and sportsinspired footwear, apparel, equipment, and accessories. The company’s May 31, 2011, balance sheet included the following ($ in millions): May 31

Prepaid expenses Income taxes payable

2011

2010

594 117

873 59

Suppose that during the fiscal year ended May 31, 2011, $366 million in cash was disbursed and charged to Prepaid Expenses. Similarly, $145 million was disbursed for income taxes and charged to Income Taxes Payable. 1. Assume that the Prepaid Expenses account relates to outlays for miscellaneous operating expenses, for example, supplies, insurance, and short-term rentals. Prepare summary journal entries for (a) the disbursements, and (b) the expenses for fiscal 2011. 2. Assume that there were no other accounts related to income taxes. Prepare summary journal entries for (a) the disbursements, and (b) the expenses for fiscal 2011.

ASSIGNMENT MATERIAL

4-48 Advance Service Contracts Diebold, Incorporated, a manufacturer of automated teller machines, showed the following current liability on the balance sheet on December 31, 2011 ($ amounts in thousands):

 OBJECTIVES 3, 5

December 31 2011 Deferred revenue

2010

$241,992

$205,173

The footnotes to the financial statements stated the following: “Deferred revenue is recorded for any services billed to customers in advance of the contract period commencing.” Assume that service contracts typically cover a 12-month period and can begin at any given month during the year. Revenue is recognized ratably over the life of the contract period. (“Recognized ratably” means an equal amount per month.) 1. Prepare summary journal entries for the creation in 2010, and subsequent earning in 2011, of the deferred revenue of $205,173. Use the following accounts: Accounts Receivable, Deferred Revenue, and Income from Advance Billings. 2. A 1-year job contract was billed to Keystone Bank on January 1, 2011, for $36,000. Work began on January 2. The full amount was collected on February 15. Prepare all pertinent journal entries through February 28, 2011. Use the following accounts: Accounts Receivable, Deferred Revenue, and Income from Service Contracts. 4-49 Journal Entries and Adjustments Northwest Natural is a public utility in Oregon. The 2011 annual report included the following footnote: Utility revenues, derived primarily from the sale and transportation of gas, are recognized upon delivery of gas commodity or service to customers. Revenues include accruals for gas delivered but not yet billed to customers based on estimates of deliveries from meter reading dates to month end (accrued unbilled revenue). Accrued unbilled revenues are dependent upon a number of factors that require management’s judgment, including total gas receipts and deliveries, customer use by billing cycle and weather factors. Accrued unbilled revenues are reversed the following month when actual billings occur. The income statements showed the following ($ in thousands): For Year Ended December 31

Gross operating revenues Income from operations

2011

2010

$848,796 144,845

$812,106 157,605

The balance sheets included the following as part of current assets ($ in thousands): December 31

Accounts receivable Accrued unbilled revenue

2011

2010

$77,449 61,925

$67,969 64,803

Prepare the adjusting journal entry for (a) the unbilled revenues at the end of 2011, and (b) the eventual billing and collection of the unbilled revenues in 2012. Ignore income taxes.

181

 OBJECTIVE 5

182

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

 OBJECTIVE 7

4-50 Classified Balance Sheet, Current Ratio, and Quick Ratio Amazon.com, Inc.’s balance sheet (slightly modified) for December 31, 2011, contained the following items ($ in millions): Property and equipment, net Accrued expenses and other Cash and cash equivalents Other noncurrent assets Inventories Other current assets Accounts payable Marketable securities, short-term Accounts receivable, net Goodwill Long-term liabilities Stockholders’ equity

$ 4,417 3,751 5,269 1,416 4,992 351 11,145 4,307 ? 1,955 2,625 7,757

1. Prepare a December 31, 2011, classified balance sheet for Amazon.com. Include the correct amount for Accounts Receivable. 2. Compute the company’s working capital, current ratio, and quick ratio. Compute the quick ratio as (current assets – inventory) ÷ current liabilities. 3. Comment on the company’s current and quick ratios. In 2010, the current ratio was 1.33 and the quick ratio was 1.02. 4. During 2011, Amazon decreased its Marketable Securities by $678. Suppose the company had not decreased its Marketable Securities but had instead decreased long-term investments (classified as Other Noncurrent Assets) by $678. How would this have affected Amazon’s current ratio? How would it have affected the company’s liquidity?

 OBJECT IVE 8

4-51 Multiple-Step Income Statement (Alternates are 4-36 and 4-40.) Intel Corporation is one of the largest companies in the United States. Its annual report for the year ended December 31, 2011, contained the following data and actual terms ($ in millions): Cost of sales Research and development Marketing, general, and administrative Amortization of acquisition-related intangibles Net revenue

$20,242 8,350 7,670 260

Gross margin Interest and other income, net Provision for taxes Gains (losses) on equity investments, net

$33,757 192 4,839 112

?

Prepare a multiple-step statement of income. Include the correct amount for Net Revenue.

 OBJECT IVES 8, 9

4-52 Single-Step Income Statement Harley-Davidson is the parent company of Harley-Davidson Motor, Buell Motorcycle, and Harley-Davidson Financial Services. It is most well-known for producing heavyweight, custom, and touring motorcycles as well as parts, accessories, and apparel. Harley-Davidson Financial Services provides wholesale and retail financing and insurance programs to dealers

ASSIGNMENT MATERIAL

183

and customers. A recent Harley-Davidson annual report contained the following slightly modified items ($ in thousands) for the year ending December 31, 2011: Investment income Cost of goods sold Financial services income Retained earnings at end of year Financial services expense

$

7,963

3,106,288 649,449 6,824,180 246,523

Other income

51,036

Restructuring expense and asset impairment

67,992

Selling, administrative, and engineering expense Interest expense Provision for income taxes Cash dividends declared Net sales revenue

$1,060,943 45,266 244,586 111,011 4,662,264

1. Prepare a combined single-step statement of income and retained earnings for the year. 2. Compute the percentage of gross profit on sales and the percentage of net income to sales. 3. The average stockholders’ equity for the year was $2,313,561. What was the percentage of net income to average stockholders’ equity? 4-53 Pharmaceutical Company Financial Statements Merck & Co., Incorporated, is a global health-care company that offers prescription medicines, vaccines, biologic therapies, animal health, and consumer care products. The annual report for the year ended December 31, 2011, included the data (slightly modified) shown next ($ in millions). Unless otherwise specified, the balance sheet amounts are the balances as of December 31, 2011. Sales Cash dividends declared Inventories Paid-in capital Other current assets Retained earnings December 31, 2010 December 31, 2011 Trade accounts payable Other expenses, net Cost of sales

$48,047 4,818 6,254 17,953 3,694 37,536 ? 2,462 816 16,871

Other current liabilities

3,271

Long-term investments

3,458

Interest expense, net

946

Long-term debt Cash and cash equivalents Accrued liabilities Short-term investments Taxes on income Property and equipment, net Other noncurrent assets Marketing and administrative expense Research and development expense Other noncurrent liabilities Income taxes payable Accounts receivable

$15,525 13,531 9,731 1,441 942 16,297 52,192 13,733 8,467 16,415 781 8,261

1. Prepare a combined multiple-step statement of income. 2. Prepare a classified balance sheet. Include the correct number for retained earnings. 3. The average common stockholders’ equity for the year was $56,874 million. What was the percentage of net income to average common stockholders’ equity? 4. The average total assets for the year were $105,454.5 million. What was the percentage of net income to average total assets? 5. Compute (a) gross profit percentage, and (b) percentage of net income to sales.

 OBJECTIVES 7, 8, 9

184

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

 OBJECT IVES 7, 8

4-54 Preparation of Financial Statements from Trial Balance The Procter & Gamble Company is one of the largest consumer products companies in America. The (slightly modified) trial balance as of June 30, 2011, appears here:

The Procter & Gamble Company Trial balance as of June 30, 2011 ($ in millions) Debits Cash and cash equivalents

$

Accounts receivable

6,275

Inventories

7,379

Deferred income taxes

1,140

Prepaid expenses and other current assets Property, plant, and equipment, at cost

4,408 41,507

Accumulated depreciation

$ 20,214

Trademarks and other intangibles, net

32,620

Goodwill

57,562

Other noncurrent assets

Credits

2,768

4,909

Debt due within one year

9,981

Accounts payable

8,022

Accrued and other liabilities

9,290

Long-term debt

22,033

Deferred income tax

11,070

Other noncurrent liabilities

9,957

Preferred stock

1,234

Common stock, stated value $1 per share

4,008

Additional paid-in capital

62,405

Retained earnings (June 30, 2010)

64,614

Accumulated other comprehensive loss*

2,054

Reserve for ESOP debt retirement*

1,357

*

Treasury stock

67,278

Noncontrolling interest*

361

Net sales

82,559

Cost of products sold

40,768

Selling, administrative, and general expense

25,973

Interest expense

831

Other nonoperating income, net

202

Income taxes

3,392

Cash dividends declared

5,729 $305,950

*

Part of stockholders’ equity.

$305,950

ASSIGNMENT MATERIAL

185

1. Prepare Procter & Gamble’s income statement for the year ended June 30, 2011, using a multiple-step format. 2. Prepare Procter & Gamble’s income statement for the year ended June 30, 2011, using a single-step format. Which format for the income statement is more informative? Why? 3. Prepare Procter & Gamble’s classified balance sheet as of June 30, 2011. 4-55 Adjusting Entries and Ethics By definition, adjusting entries are not triggered by an explicit event. Therefore, accountants must initiate adjusting entries. For each of the following adjusting entries, discuss a potential unethical behavior that an accountant or manager might undertake: 1. 2. 3. 4.

 OBJECTIVES 2,3,4,5

Recognition of expenses from the prepaid supplies account Recognition of revenue from the unearned revenue account Accrual of interest payable Accrual of fees receivable

Collaborative Learning Exercise 4-56 Implicit Transactions Form groups of from three to six “players.” Each group should have a die and a paper (or board) with four columns labeled as follows: 1. 2. 3. 4.

Expiration or consumption of unexpired costs Earning of unearned revenues Accrual of unrecorded expenses Accrual of unrecorded revenues

The players should select an order in which they want to play. Then, the first player rolls the die. If this player rolls a 5 or 6, the die passes to the next player. If the second player rolls a 1, 2, 3, or 4, this person must, within 20 seconds, name an example of a transaction that fits in the corresponding category; for example, if a 2 is rolled, the player must give an example of earning of unearned revenues. Each time a correct example is given, the player receives one point. If someone doubts the correctness of a given example, the player can challenge it. If the remaining players unanimously agree that the example is incorrect, the challenger gets a point and the player giving the example does not get a point for a correct example and is out of the game. If the remaining players do not unanimously agree that the answer is incorrect, the challenger loses a point and the player giving the example gets a point for a correct example. If a player fails to give an example within the time limit or gives an incorrect example, this person is out of the game (except for voting when an example is challenged), and the remaining players continue until everyone has failed to give a correct example within the time limit. Each correct answer should be listed under the appropriate column. The player with the most points is the group winner. When all groups have finished a round of play, a second level of play can begin. The groups can get together and list all examples for each of the four categories by group. Discussion can establish the correctness of each entry; the faculty member or an appointed discussion leader will be the final arbitrator of the correctness of each entry. Each group gets one point for each correct example and loses one point for each incorrect entry. The group with the most points is the overall winner.

 OBJECTIVES 2,3,4,5

186

CHAPTER 4 • ACCRUAL ACCOUNTING AND FINANCIAL STATEMENTS

Analyzing and Interpreting Financial Statements  OBJECT IVES 7, 9

4-57 Financial Statement Research Select any two companies. 1. For each company, determine the amount of working capital and the current ratio. 2. Compare the current ratios. Which company has the larger ratio, and what do the ratios tell you about the liquidity of the companies? 3. Compute the gross margin percentage, the return on sales, and the return on common stockholders’ equity. 4. Compare the profitability of the two companies.

 OBJECT IVES 2, 4

4-58 Analyzing Starbucks’ Financial Statements This problem develops skills in preparing adjusting journal entries. The balance sheet of Starbucks for the year ended October 2, 2011, included the following information (all $ amounts in millions).

Prepaid expenses and other current assets Other accrued expenses

October 2, 2011

October 3, 2010

$161.5 319.0

$156.5 262.8

Suppose that during the year ended October 2, 2011, $207.5 million cash was disbursed and debited to Prepaid Expenses and $279.3 million of liabilities classified as Other Accrued Expenses were paid in cash. 1. Assume that the Prepaid Expenses account relates to outlays for miscellaneous operating expenses, for example, supplies, insurance, and short-term rentals. Prepare summary journal entries for (a) the disbursements, and (b) the expenses (for our purposes, debit Operating Expenses) for the year ended October 2, 2011. Post the entries to T-accounts. 2. Prepare summary journal entries for (a) the disbursements, and (b) the expenses related to the Other Accrued Expenses account for the year ended October 2, 2011. (For our purposes, debit Operating Expenses.) Post the entries to T-accounts.

 OBJECT IVES 7, 9

4-59 Analyzing Financial Statements Using the Internet Go to www.columbia.com to find Columbia Sportswear’s home page. Under the About Us menu near the bottom of the page, select Investor Relations. Then select Financial Information and click on the most recent annual report. You may also select the most recent Form 10-K. Answer the following questions: 1. Name one item on Columbia Sportswear’s balance sheet that most likely represents unexpired (prepaid) costs. Name one item that most likely represents the accrual of unrecorded expenses. 2. Does Columbia Sportswear prepare a single- or multiple-step income statement? How can you tell?

ASSIGNMENT MATERIAL

3. Determine Columbia Sportswear’s gross profit percentage for the past 2 years. Is the change favorable? What does Columbia Sportswear’s management say about the change? (Hint: Look in Management’s Discussion and Analysis.) If nothing was said, why do you think management chose not to comment? How do you think management determines the reason that gross profit changed, given the condensed nature of the income statement? 4. Calculate Columbia Sportswear’s current ratio for the past 2 years. Did this ratio improve or decline? Does management offer any comment about any particular problems that could have affected this ratio? Should management be concerned about changes in the current ratio? 5. Where can you find evidence in Columbia Sportswear’s annual report that the financial statements were prepared using U.S. GAAP?

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5

Statement of Cash Flows COSTCO OPERATES NEARLY 600 MEMBERSHIP warehouses in the United States and seven other countries. You may be one of the more than 64 million members who shop in Costco stores. The company offers its members “low prices on a limited selection of nationally branded and private-label products in a wide range of merchandise categories.” Costco began operations in 1983 with a single warehouse in Seattle, Washington. In just three decades it has grown into the third largest retailer based in the U.S. and the seventh largest retailer in the world. Costco stocks a small number of items, about 3,600 compared with more than 100,000 at many department and grocery stores, and sells most items in large quantities. Its annual sales in fiscal 2011 were nearly $90 billion. Each year Costco needs cash to build new warehouses and stock them with merchandise. A quick look at the company’s balance sheet tells you Costco has plenty of cash—more than $4 billion on August 28, 2011. However, if you truly want to see where Costco spends its cash, you should pay attention to one specific financial report—the statement of cash flows. Costco reports the cash provided or used by the company for operating, investing, and financing activities, giving you a complete picture of how the company generated the money and how it was spent. For example, in recent years, operating activities such as selling merchandise and memberships have provided billions in cash for Costco ($3.2 billion in 2011). In contrast, investing and financing activities have used cash, primarily because Costco invested heavily in property and equipment and spent millions of dollars buying back shares of its own stock as well as paying dividends. The net result of these activities in 2011 was an increase in cash of $795 million over the previous year’s balance. You can learn all of this from the company’s statement of cash flows.



LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Identify the purposes of the statement of cash flows. 2 Classify activities affecting cash as operating, investing, or financing activities. 3 Compute and interpret cash flows from financing activities. 4 Compute and interpret cash flows from investing activities.

5 Use the direct method to calculate cash flows from operations.

computing cash flows from operating activities.

6 Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities.

8 Show how the balance sheet equation provides a conceptual framework for the statement of cash flows.

7 Understand why we add depreciation to net income when using the indirect method for

9 Identify free cash flow, and interpret information in the statement of cash flows.

The critical importance of cash makes the statement of cash flows one of the key financial statements. The statement explains the changes that occur in the firm’s cash balance during the year. The statement of cash flows allows both investors and managers to keep their fingers on the pulse of any company’s lifeblood—cash. Attitudes toward holding cash vary. Some managers and investors like the safety of large amounts of cash. For example, after the great recession of 2008–2011 many companies held onto large amounts of cash to provide flexibility to meet unforeseen needs. Microsoft, for instance, held $57 billion in cash, cash equivalents, and short-term investments in early 2012. In contrast, other companies minimized cash holdings, even during the recession, because cash provides only small returns to the company. Companies that lose too much cash may find it necessary to declare bankruptcy. Bankruptcy means that a company seeks court protection from its creditors under federal law. Court protection allows a firm to delay paying certain obligations while it negotiates with its creditors to reorganize its business and settle its debts. Enron and General Motors are recent examples of large and historically successful companies that entered bankruptcy and either liquidated entirely (Enron) or reorganized large portions of their business (GM). We observed bankruptcies of many large companies in the economic downturns of 2001–2002 and 2008–2011. Although managers and investors benefit from watching cash flows, until recently many countries did not require a statement of cash flows. For example, India began to require such a statement about 10 years ago. Today, both the IASB and FASB require a statement of cash flows and have similar requirements for the statement. In this chapter, we examine cash flow statements and explain how managers and investors use the information in such statements.

Overview of Statement of Cash Flows A balance sheet shows the amount of cash a company holds at the close of business on the balance sheet date. But it does not show how the company generated this cash balance. For that, you need a statement of cash flows. The statement of cash flows (or cash flow statement) reports

Costco attracts a wide variety of shoppers—old and young, urban and rural, and of all ethnic backgrounds—who buy memberships that allow them to purchase items in large quantities at low prices. Cash flows are critical to Costco. bankruptcy When a company seeks court protection from its creditors under federal law.

statement of cash flows (cash flow statement) One of the basic financial statements that reports the cash receipts and cash payments of an entity during a particular period and classifies them as financing, investing, and operating cash flows.

189

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CHAPTER 5 • STATEMENT OF CASH FLOWS

the cash receipts and cash payments of an entity during a particular period and classifies them as financing, investing, or operating cash flows. Statements of cash flows, like income statements, show the performance of a company over a period of time. Both help explain why the balance sheet items have changed—the income statement shows details about how operating activities produce changes in retained earnings, while the statement of cash flows provides a detailed explanation of the changes in the cash account. As the following diagram shows, these statements link the balance sheets in consecutive periods:

Balance Sheet December 31, 20X0

Balance Sheet December 31, 20X1

Statement of Income

Statement of Cash Flows

cash equivalents Highly liquid short-term investments that a company can easily and quickly convert into cash, such as money market funds and Treasury bills.

 OBJECTIVE 1 Identify the purposes of the statement of cash flows.

cash flows from operating activities The first major section of the cash flow statement. It helps users evaluate the cash impact of management’s operating decisions.

operating activities Transactions that affect the purchase, processing, and selling of a company’s products and services.

 OBJECTIVE 2 Classify activities affecting cash as operating, investing, or financing activities.

cash flows from financing activities The section of the statement of cash flows that helps users understand management’s financing decisions.

Purposes of Cash Flow Statement Why do managers and investors use a statement of cash flows? 1. It helps them understand the relationship of net income to changes in cash balances. Cash balances can decline despite positive net income and vice versa. 2. It reports past cash flows as an aid to a. predicting future cash flows, b. evaluating how management generates and uses cash, and c. determining a company’s ability to pay interest, dividends, and debts when they are due. 3. It identifies specific increases and decreases in a firm’s productive assets. The statement of cash flows explains how a company generates cash during a period and how it uses cash. It helps investors assess how well management has managed cash. The importance of cash management is discussed in the Business First box on p. 191. Before continuing with our discussion of cash flows, let’s first be clear about what we mean by cash. Our use of the term refers not only to the currency and bank accounts that we all call cash but also to cash equivalents. Cash equivalents are highly liquid short-term investments that a company can easily and quickly convert into cash, such as money market funds and Treasury bills. Hereafter, when we refer to cash, we mean both cash and cash equivalents.

Typical Activities Affecting Cash Managers affect cash as the result of three types of decisions: operating, financing, and investing decisions. Operating decisions affect the major day-to-day activities that generate revenues and expenses. The first major section of the statement of cash flows, cash flows from operating activities, summarizes the cash impact of such decisions. Operating activities are transactions that affect the purchase, processing, and selling of a company’s products and services. For example, making sales, collecting accounts receivable, recording an expense for cost of goods sold, purchasing inventory, and paying accounts payable or employee wages are all operating activities. The thing these transactions have in common is that they are an integral part of the major income-generating activities of the company. Managers make financing decisions when they decide whether and how to raise or repay cash. For example, when a company needs cash, financial managers may decide whether to

191

OVERVIEW OF STATEMENT OF CASH FLOWS

BUSINESS FIRST CASH MANAGEMENT The recession in 2008–2011 tested the cash management of many companies. During the later stages of this recession, companies were holding more cash than at any time in the last 40 years. For example, Google nearly quadrupled its holdings of cash and marketable securities in the 5 years leading up to 2012, Microsoft increased its cash and marketable securities from less than $24 billion at the end of 2008 to more than $57   billion in early 2012, and PepsiCo increased its cash from under $1 billion in 2007 to almost $6 billion in 2011. This was partly a reaction to the financial crisis in the early years of the recession when it was nearly impossible to raise cash. But the retention of cash also allowed these companies to be poised to invest when the economy turned around. While some companies hoarded cash, others did not have enough cash to meet their obligations and had to file for bankruptcy. Probably the most famous bankruptcy was that of Lehman Brothers, a global financial services firm, in September 2008. Not only was Lehman’s bankruptcy a major blow to the U.S. economy, dropping the Dow Jones Average by more than 500 points in one day, it inspired several books and even a popular movie, Margin Call . But many other familiar companies declared bankruptcy around that time, including Hollywood Video, Levitz, Sharper Image , Linens ’n Things , and Circuit City. More recently, as the recession continued, large companies such as General Motors, American Airlines, and MF Global followed suit. Let’s look at one company’s descent into bankruptcy, that of Blockbuster. The

following table shows selected financial data for Blockbuster (in millions): Year ended:

Jan. 2, 2011

Jan. 3, 2010

Jan. 4, 2009

Jan. 6, 2008

Total assets

$1,184

$1,538

$2,155

$2,734

1,736

1,853

1,940

2,078

Net cash flow from operations

11

29

51

(56)

Capital expenditures

24

32

118

74

Total liabilities

Until the year that ended on January 3, 2010, Blockbuster had total assets greater than total liabilities, leaving positive stockholders’ equity. But total liabilities exceeded total assets for the last two years. Examination of the cash flow statement provides insight into Blockbuster’s financial difficulties. In all 4 years Blockbuster spent more to purchase capital assets than it generated in operating cash flow. It is hard for a company to stay in business if its operations do not generate enough cash to cover its capital expenditures. So, as successful companies piled up cash, many less successful ones such as Blockbuster declared bankruptcy. Some, such as General Motors, used bankruptcy as a means of reorganizing and staying in business. Others, such as Linens ’n Things, reorganized under new ownership. But many bankrupt companies simply liquidated by selling their assets and using the proceeds to pay off some portion of their debts. Sources: T. McGinty, and C. Tuna, “Jittery Companies Stash Cash,” Wall Street Journal (November 3, 2009, p. A1); Blockbuster 10-K filings for years ending Jan. 2, 2011, Jan. 3, 2010, Jan. 4, 2009, and Jan. 6, 2008.

borrow money from a bank or other lender or issue additional capital stock. When there is excess cash, financial managers may decide to repay previous borrowings or to buy back previously issued stock. To understand financing decisions, we use the section of the statement of cash flows labeled cash flows from financing activities. Financing activities are a company’s transactions that obtain resources by borrowing from creditors or selling shares of stock and use resources to repay creditors or provide a return to shareholders. After raising capital, managers must decide how to invest the capital. These investing decisions include the choices to (1) acquire or dispose of plant, property, equipment, and other long-term productive assets, and (2) provide or collect cash as a lender or as an owner of securities. The statement of cash flows covers the results of investing decisions in a section labeled cash flows from investing activities. Investing activities are transactions that acquire or dispose of long-lived assets or acquire or dispose of securities held for investment purposes that are not cash equivalents. Thus, purchasing property or equipment is an investing activity, but purchasing inventory or prepaying rent are operating activities. Why? Because a company will generally use property and equipment for multiple years, whereas it will use inventory and prepaid rent within one year.

financing activities A company’s transactions that obtain resources by borrowing from creditors or selling shares of stock and use resources to repay creditors or provide a return to shareholders.

cash flows from investing activities The section of the statement of cash flows that helps users understand management’s investing decisions.

investing activities Transactions that acquire or dispose of long-lived assets or acquire or dispose of securities held for investment purposes that are not cash equivalents.

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CHAPTER 5 • STATEMENT OF CASH FLOWS

EXHIBIT 5-1 Typical Operating, Investing, and Financing Activities

Cash Inflows

Cash Outflows

Operating activities Cash payments to suppliers Cash payments to employees Interest and taxes paid Other operating cash payments Investing activities Sale of property, plant, and equipment Purchase of property, plant, and equipment Sale of securities that are not cash Purchase of securities that are not equivalents cash equivalents Receipt of loan repayments Making loans Financing activities Borrowing cash from creditors Repayment of amounts borrowed Issuing equity securities Repurchase of equity shares Issuing debt securities Payment of dividends Collections from customers Interest and dividends collected Other operating receipts

There is one more item you will see on the cash flow statements of companies with international operations—the effect of exchange rates on cash. Companies show this effect after the operating, investing, and financing activities. The effect of exchange rates is not a cash flow, but it appears on the cash flow statement because it is necessary for the reconciliation of cash balances at the beginning and end of the period. Consider a U.S. company with a bank account in London. The account balance is £100,000 at the beginning of the year when the exchange rate is 2 U.S. dollars for every British pound. The company would include this bank account as part of its total cash balance on a U.S. balance sheet at a value of (£100,000 × $2/£) = $200,000. Suppose there were no cash flows into or out of the bank account during the year, but the exchange rate changed to $1.7 per pound. At the end of the year, a U.S. balance sheet would include this bank account at a value of (£100,000 × $1.7/£) = $170,000. Cash measured in dollars fell by $30,000 in the absence of any cash flow. This change in cash is reported on the cash flow statement as the effect of exchange rates on cash. Exhibit 5-1 shows typical operating, investing, and financing activities reported in a statement of cash flows. The fact that these activities affect cash should be fairly obvious and straightforward. What is not always obvious is the classification of these activities as operating, investing, or financing. Consider interest payments and dividend payments, for example. These both represent cash flows to those who supply capital to the firm. You might think they should be classified the same. However, U.S. GAAP classifies interest payments as cash flows associated with operations and dividend payments as financing cash flows. This classification maintains the long-standing distinction that transactions with owners (dividends) are not part of a company’s routine operating activities and cannot be treated as expenses, whereas interest payments to creditors are expenses. In addition, both dividends and interest received are operating activities under U.S. GAAP. Most companies reporting under IFRS use the same method as those reporting under U.S. GAAP. However, companies using IFRS have other options. They may classify dividend or interest payments as either operating or financing activities. Further, IFRS allows companies to classify interest or dividend receipts as either operating or investing activities, as long as the classification is consistent across periods.

Preparing a Statement of Cash Flows To see how various activities affect the statement of cash flows, consider the activities of Biwheels Company for January 20X2. We reproduce the company’s transactions in balance sheet equation format in Exhibit 5-2 and display the resulting balance sheet and income statement in Exhibit 5-3. We use these exhibits to prepare a statement of cash flows for Biwheels for January 20X2. Notice that the cash balance for Biwheels increased from $0 at the beginning of

EXHIBIT 5-2 Biwheels Company Analysis of Transactions for January 20X2 (in $) Assets Description of Transactions

Cash

=

Accounts Merchandise Prepaid Store + Receivable + Inventory + Rent + Equipment =

Liabilities Note Payable

(1) Initial investment

+400,000

=

(2) Loan from bank

+100,000

= +100,000

(3) Acquire store equipment for cash

–15,000

(4) Acquire inventory for cash

–120,000

(7) Sale of equipment

–10,000

=

+10,000

=

+10,000

+30,000

=

+20,000

–800

+160,000

(10b) Cost of merchandise inventory sold

–100,000

(11) Collect accounts receivable

+5,000

(12) Pay rent in advance

–6,000

+

Retained Earnings

–1,000 =

–4,000

(10a) Sales on open account

Paid-in Capital +400,000

+120,000

+1,000

(8) Return of inventory acquired on January 6 (9) Payment to creditor

Accounts Payable +

Stockholders’ Equity

+15,000 =

(5) Acquire inventory on credit (6) Acquire inventory for cash plus credit

+

+

–5,000

=

–800

=

–4,000

=

+160,000

=

–100,000

=

(13) Recognize expiration of rental services

+6,000

=

–2,000

=

–2,000

–100 =

–100

(14) Depreciation Balance, January 31, 20X2

351,000

+155,000

+59,200

+4,000

+13,900 =

100,000

+25,200

+400,000

+57,900

¯˚˚˚˚˚˘˚˚˚˚˚˙ ¯˚˚˚˚˚˘˚˚˚˚˚˙ 583,100

583,100

193

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CHAPTER 5 • STATEMENT OF CASH FLOWS

EXHIBIT 5-3 Biwheels Company’s Income Statement and Balance Sheet

Income Statement, for the Month Ended January 31, 20X2 Sales revenue Deduct expenses Cost of goods sold Rent Depreciation

$160,000 $100,000 2,000 100

Total expenses Net income

102,100 $ 57,900

Balance Sheet, January 31, 20X2 Assets Cash Accounts receivable Merchandise inventory Prepaid rent Store equipment, net

Total assets

Liabilities and Stockholders’ Equity $351,000 155,000 59,200 4,000 13,900

$583,100

Liabilities: Note payable Accounts payable Total liabilities Stockholders’ equity: Paid-in capital Retained earnings Total stockholders’ equity Total liabilities and stockholders’ equity

$100,000 25,200 125,200 $400,000 57,900 457,900 $583,100

the month to $351,000 at the end of the month. Because the statement of cash flows explains the changes in cash, the first step in developing the statement is always to compute the amount of the change, in this case an increase of $351,000. Next we examine the three sections of the statement of cash flows that combine to explain this $351,000 increase.

 OBJECTIVE 3 Compute and interpret cash flows from financing activities.

Cash Flows from Financing Activities Although most companies list operating activities as the first section of the cash flow statement, we will begin our discussion with the more easily described and understood section, cash flows from financing activities. Further, financing activities were the first transactions in the launching of Biwheels Company. The financing activities section shows cash flows to and from providers of capital. The easiest way to determine cash flows from financing activities is to examine changes in the cash account in the balance sheet equation (or T-account) and identify those changes associated with financing activities. Exhibit 5-2 shows that Biwheels had two such transactions in January: Transaction 1, Initial investment, $400,000 Transaction 2, Loan from bank, $100,000 Both of these transactions are cash inflows, that is, increases in cash. Therefore, Biwheels’ cash flows from financing activities total $500,000: Biwheels Company Cash Flows from Financing Activities for the Month of January 20X2 Proceeds from initial investment Proceeds from bank loan Net cash provided by financing activities

$400,000 100,000 $500,000

PREPARING A STATEMENT OF CASH FLOWS

195

If you did not have access to the balance sheet equation entries, you could also look at the changes in Biwheels’ balance sheet during January. Note that all balance sheet accounts were zero at the beginning of the month. You can compute the increases in Note Payable and Paid-in Capital as follows: Balance, January 1, 20X2

Balance, January 31, 20X2

Increase (Decrease)

$0 0

$100,000 400,000

$100,000 400,000

Note payable Paid-in capital

If stockholders’ had invested $100,000 on December 31, 20X1 and the remaining $300,000 on January 2, 20X2, the cash inflow for January 20X2 from the investment would have been only $300,000: Balance, January 1, 20X2

Balance, January 31, 20X2

Increase (Decrease)

$100,000

$400,000

$300,000

Paid-in capital

Two general rules for financing activities are as follows: • Increases in cash (cash inflows) stem from increases in liabilities or paid-in capital • Decreases in cash (cash outflows) stem from decreases in liabilities or paid-in capital You can see a list of some financing activities and their effect on cash in the first part of Exhibit 5-4. For example, selling common shares increases cash (+), paying dividends decreases cash (–), and converting debt into common stock has no effect on cash. In addition, note that the transactions classified as financing activities do not affect net income. The relevance of this distinction will become more evident when we discuss cash flows from operations.

Cash Flows from Investing Activities The section of the cash flow statement called cash flows from investing activities lists cash flows from the purchase or sale of plant, property, equipment, and other long-lived assets. It is usually the second section in the cash flow statement. To determine the cash flows from investing activities, look at transactions that increase or decrease long-lived assets, loans, or securities that are Type of Transaction

Increase (+) or Decrease (–) in Cash

Financing Activities Increase long- or short-term debt

+

Reduce long- or short-term debt



Sell common shares

+

Repurchase common shares



Pay dividends



Convert debt to common stock

No effect

Investing Activities Purchase fixed assets for cash Purchase fixed assets by issuing debt

– No effect

Sell fixed assets for cash

+

Purchase for cash investment securities of other firms that are not cash equivalents



Sell for cash investment securities in other firms that are not cash equivalents

+

Make a loan to another company or person



Collect a loan

+

 OBJECTIVE 4

Compute and interpret cash flows from investing activities.

EXHIBIT 5-4 Analysis of Effects of Financing and Investing Transactions on Cash

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CHAPTER 5 • STATEMENT OF CASH FLOWS

not considered cash equivalents. Biwheels has only one such asset, Store Equipment. There were two cash transactions relating to store equipment during January: Transaction 3, Acquire store equipment for cash, $15,000 Transaction 7, Sale of asset [store equipment] for cash, $1,000 The first of these transactions is a use of cash, or a cash outflow. The second is a source of cash, or a cash inflow. The investing activities section of Biwheels’ cash flow statement is as follows: Biwheels Company Cash Flows from Investing Activities for the Month of January 20X2 Purchase of store equipment Proceeds from sale of store equipment Net cash used by investing activities

$(15,000) 1,000 $(14,000)

Notice that we place the cash outflows in parentheses. Because there is a net cash outflow, investing activities used cash during January. This contrasts with financing activities, which provided cash. The second part of Exhibit 5-4 shows types of investing activities and their effects on cash. For example, selling investment securities (except for securities that are cash equivalents) increases cash (+) and making a loan decreases cash (–). Notice that buying or selling securities that are cash equivalents does not change cash. It simply turns one type of cash into another type of cash. If you did not have access to the transactions listed in the balance sheet equation, you would need to look at changes in the long-lived assets, loans, and other investments on the balance sheet. Two general rules for investing activities are as follows: • Increases in cash (cash inflows) stem from sale of long-lived assets, collection of loans made to others, and sale of investments • Decreases in cash (cash outflows) stem from purchases of long-lived assets, granting of loans to others, and purchases of investments Consider Biwheels’ only long-lived asset, Store Equipment. Changes in the net amount of such assets generally result from three possible sources—(1) asset acquisitions, (2) asset disposals, and (3) depreciation expense for the period: Change in assets = Acquisitions - Disposals - Depreciation expense Asset acquisitions and disposals may involve cash, but depreciation has no impact on cash. It is not a cash outflow. Thus, it is important to identify how much of the change in the asset values resulted from the recognition of depreciation. From the balance sheet, we learn that the net amount of Biwheels’ Store Equipment increased from $0 to $13,900 in January. From the income statement, we know that Depreciation Expense was $100. Thus, we know that the net acquisitions (that is, acquisitions less disposals) were $14,000: $13,900 = Acquisitions - Disposals - $100 Acquisitions - Disposals = $13,900 + $100 = $14,000 Only by knowing more about either the actual acquisitions or disposals can we break down net acquisitions into acquisitions and disposals. In this case we know that Biwheels’ acquisitions were $15,000, so disposals must have been ($15,000 – $14,000) = $1,000. If we had not known the amount of acquisitions but knew that disposals were $1,000, we could compute acquisitions as ($14,000 + $1,000) = $15,000. Management has no problem examining financial records

PREPARING A STATEMENT OF CASH FLOWS

197

directly to determine the details about acquisitions and disposals, but investors have a more difficult time obtaining such details.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S A company raised $1 million by selling common stock. The company put $400,000 into securities that are cash equivalents and used the other $600,000 to buy equipment. What are the effects of these transactions on the cash flow statement?

Because the securities are cash equivalents, the $400,000 does not appear in the investing section; instead, it is simply a rearrangement of the form in which the company holds cash. The net increase in cash from these transactions is $400,000, or $1 million from financing less $600,000 used for investing.

Answer The $1 million appears as cash provided by financing activities. The $600,000 appears as a use of cash in the investing section.

Noncash Investing and Financing Activities Some financing or investing activities do not affect cash. Companies list such activities in a separate schedule accompanying the statement of cash flows. In our example, Biwheels Company did not engage in any noncash investing or financing activities. However, suppose Biwheels’ purchase of the store equipment was not for cash, but was financed as follows: A. Biwheels acquired $8,000 of the store equipment by issuing common stock. B. Biwheels acquired the other $7,000 of store equipment by signing a note payable for $7,000. Also consider one other possible transaction: C. Biwheels converted $50,000 of its original note payable to common stock. That is, Biwheels issued $50,000 of common stock in exchange for a reduction of $50,000 in the note payable. These items would affect the balance sheet equation as follows:

A. B. C.

Cash 0 0 0

+

Store Equipment +$8,000

= =

+$7,000

= =

Note Payable +$ 7,000 –$50,000

+

Paid-in Capital +$ 8,000 +$50,000

None of these transactions affect cash; therefore, they do not belong in a statement of cash flows. However, each transaction could just as easily involve cash. For example, in the first transaction, the company might issue common stock for $8,000 cash and immediately use the cash to purchase the fixed asset. The financing cash inflow and investing cash outflow would then both appear on the statement of cash flows. Because of the importance of these noncash investing and financing decisions, readers of financial statements want to be informed of such noncash activities. Companies must report such items in a schedule of noncash investing and financing activities. Biwheels Company’s schedule for hypothetical transactions A, B, and C would be as follows: Schedule of noncash investing and financing activities Common stock issued to acquire store equipment Note payable for acquisition of store equipment Common stock issued on conversion of note payable

$ 8,000 $ 7,000 $50,000

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CHAPTER 5 • STATEMENT OF CASH FLOWS

Summary Problem for Your Review PROBLEM Examine the entries to Biwheels’ balance sheet equation for February 20X2 in Exhibit 2-5 (p. 60) and the final February transaction, transaction 22, declaration and payment of dividends of $50,000 (p. 61). 1. Identify the transactions that belong in the financing and investing sections of the statement of cash flows for February. 2. Assume that Biwheels has two additional transactions during February: a. Bought shares of common stock of Pacific Cycle for $12,000 cash. b. Bought a $30,000 storage shed for $8,000 cash and signed a note payable for the remaining $22,000. The company financed the $8,000 for the cash down payment by borrowing $8,000 cash from the bank and then using it for the down payment. How would these transactions affect the financing and investing sections of Biwheels’ February statement of cash flows? 3. Prepare the financing and investing sections of Biwheels’ statement of cash flows including all transactions in parts 1 and 2 of this problem. Include a schedule of noncash investing and financing activities if appropriate. Interpret the information you learn from these two sections.

SOLUTION 1. Only transaction 21, borrowing of $10,000 from the bank and using that $10,000 to buy store equipment, and transaction 22, payment of cash dividends of $50,000, involve financing or investing activities. The $10,000 loan is a financing activity, the $10,000 paid to buy the store equipment is an investing activity, and the $50,000 of dividends paid is a financing activity. 2. The $12,000 paid for Pacific Cycle shares is an investing activity. The purchase of the storage shed has three effects: (1) The $8,000 paid in cash is an investing activity, (2) the $8,000 borrowed from the bank is a financing activity, and (3) the $22,000 acquisition for a note payable is a noncash investing and financing activity. 3. The statement of cash flows would include the following. Note that we combined the two borrowings from the bank into one line: ($10,000 + $8,000) = $18,000. Biwheels Company Cash Flows from Financing and Investing Activities for the Month of February 20X2 Cash Flows from Investing Activities Acquisition of store equipment Purchase of Pacific Cycle common shares Acquisition of storage shed Net cash used for investing activities Cash Flows from Financing Activities Borrowing from banks Payment of dividends Net cash used by financing activities Noncash Investing and Financing Activities Note payable financing for purchase of storage shed

$(10,000) (12,000) (8,000) $(30,000) $ 18,000 (50,000) $(32,000) $ 22,000

From these sections of the cash flow statement, we learn that in February Biwheels used a total of $62,000 in cash for investing and financing activities. Either the company used cash generated by operations or it depleted its cash balance to support these activities. Of the $30,000 spent for investing activities, $18,000 increased long-lived assets and $12,000 increased Biwheels’ investment in the securities of another company, Pacific Cycle. We also learn that the $18,000 in cash inflows from financing was entirely debt financing, borrowing from banks. The company did not sell or buy back any shares of its common stock. The $50,000 cash outflow for dividends was

CASH FLOW FROM OPERATING ACTIVITIES

199

larger than the additional borrowing, resulting in a net cash outflow of $32,000 from financing activities. Finally, Biwheels also invested another $22,000 in the storage shed and financed it with debt in the form of a note payable. This transaction involved both a financing activity and an investing activity, but it had no effect on cash.

Cash Flows from Operating Activities Users of financial statements appreciate information about management’s ability to make financial and investment decisions. However, they often are more concerned with assessing management’s operating decisions. They focus on the first section of cash flow statements, cash flows from operating activities (or cash flows from operations), which shows the cash effects of transactions that involve the major income-generating activities of the company. As noted earlier, these are activities that affect the purchase, processing, and selling of a company’s products and services—in other words, the transactions that affect the income statement.

Approaches to Calculating the Cash Flows from Operating Activities Under current U.S. GAAP, companies can use either of two approaches to compute cash flows from operating activities (or cash flows from operations). The direct method subtracts operating cash disbursements from operating cash collections to arrive at net cash flow from operations. The indirect method starts with the accrual net income from the income statement and adjusts it to reflect only those income statement activities that involve actual cash receipts and cash disbursements. Both methods produce the same amount of net cash provided by (or used for) operating activities. The only difference is the format of the operating section of the cash flow statement. Both the IASB and FASB prefer the direct method because it is a straightforward listing of cash inflows and cash outflows and is easier for investors to understand. As indicated in the Business First box on p. 200, the two Boards are likely to go a step further in the near future and issue a standard that requires companies to use the direct method. Although we will discuss the direct method first, you also need to understand the indirect method because many companies will continue to use it until the standards force them to change. Before addressing the details of the direct and indirect methods, consider the types of cash flows that accountants classify as operating activities. Exhibit 5-5 lists many such activities. Type of Transaction

Increase (+) or Decrease (–) in Cash

Operating Activities Sell goods and services for cash

+

Sell goods and services on credit

No effect

Collect accounts receivable

+

Receive dividends or interest

+

Recognize cost of goods sold

No effect

Purchase inventory for cash



Purchase inventory on credit

No effect

Pay accounts payable Accrue operating expenses Pay operating expenses Accrue taxes Pay taxes Accrue interest Pay interest Prepay expenses for cash

– No effect – No effect – No effect – –

Record the use of prepaid expenses

No effect

Charge depreciation

No effect

direct method A method for computing cash flows from operating activities that subtracts operating cash disbursements from operating cash collections to arrive at cash flows from operations.

indirect method A method for computing cash flows from operating activities that adjusts the previously calculated accrual net income from the income statement to reflect only those income statement activities that involve actual cash receipts and cash disbursements.

EXHIBIT 5-5 Analysis of Effects of Operating Transactions on Cash

200

CHAPTER 5 • STATEMENT OF CASH FLOWS

BUSINESS FIRST ACCOUNTING CHANGES ON THE HORIZON: F I N A N C I A L S TAT E M E N T P R E S E N TAT I O N Generally accepted accounting principles (GAAP) are continually changing. Both the FASB and IASB issue new standards that either improve previous standards or address new issues that arise as the nature of business and the economy changes. Most new accounting standards today involve a joint effort of the FASB and IASB. One such effort is the Financial Statement Presentation Project. As part of their effort to converge U.S. GAAP and IFRS, in April 2004 the FASB and IASB set out to work together on major revisions to the required format for companies’ financial statements. We will discuss two changes that, if adopted, would directly alter the statement of cash flows. We will also discuss one change that would affect all three of the basic financial statements: the balance sheet, the income statement, and the statement of cash flows. With respect to the statement of cash flows, the proposed standard would require the use of the direct method. Almost all companies today use the indirect method, so those companies would have to change the format of their statement. The proposed standard would also prohibit the combining of cash and cash equivalents. Companies would have to include all items currently called cash equivalents in their short-term investments section, not as part of cash. Probably the most sweeping and controversial proposed change is to organize the basic financial statements into a set of categories that are more cohesive across the statements than are current statement formats. For the balance sheet and income statement, these categories would be similar, but not identical, to  the statement of cash flows format that divides activities into operating, investing, and financing activities. For example, the balance sheet and income statement would have a Business section, which would

be divided into operating and investing categories, and a Financing section, which would be separated into debt and equity categories. In addition, there would be a separate section for taxes payable, both current and deferred. A balance sheet would be organized something like this: BUSINESS Operating assets and liabilities . . Investing assets and liabilities . . FINANCING Debt category . . Equity category . . INCOME TAXES

The Boards are still working on this project. Progress has been slow, and there is no projected date for releasing a proposed draft of the new standards. Nevertheless, many accountants believe that at some future date both Boards will require new presentation formats. Sources: G. McClain, and A. J. McLelland, “Shaking Up Financial Statement Presentation,” Journal of Accountancy, November 2008, pp. 56–64; Financial Accounting Standards Board, Project Updates (last update May 3, 2011), http://www.fasb.org/financial_ statement_presentation.shtml.

These cash flows are associated with revenues and expenses on the income statement. Notice that recording revenue from the sales of goods or services does not necessarily increase cash. Only sales for cash immediately increase cash. There is no cash effect of credit sales until the customer actually pays. Biwheels must collect its accounts receivable to generate any cash. Similarly, cash received for services to be performed in the future is an operating cash inflow recognized in the statement of cash flows even though a company may not earn and record the revenue until a later period. The cash effects of expenses are similar. Sometimes the cash outflow precedes the recording of the expense on the income statement. For example, Biwheels incurred a $6,000 cash outflow for prepaid rent in January and recorded the $6,000 as an asset. The entire $6,000 would appear

CASH FLOWS FROM OPERATING ACTIVITIES

on January’s statement of cash flows. The company does not record rent expense on the income statement until later, when it uses the rented facilities. The entries that recognize rent expense and reduce the Prepaid Rent account do not affect cash. In other cases, the cash outflow follows the recording of the expense, as may occur with payment of wages. The statement of cash flows reports wages when the company actually disburses cash to employees, not when it records the wages expense. Let’s examine the cost of goods sold expense. Accounting for the acquisition and sale of inventory usually requires recording three transactions: (1) purchase of inventory on credit, (2) payment of accounts payable, and (3) delivery of goods to the customer and thus the recording of an expense, where steps (2) and (3) may occur in either order. If the purchase of inventory is for cash, steps 1 and 2 combine to form a single transaction. Consider the following Biwheels transactions. Biwheels bought a bicycle seat on credit for $30 on June 7. Biwheels sold the seat on June 29 and paid the supplier in full on July 7. Two transactions occurred during June: 1. June 7. The balance sheet accounts Merchandise Inventory and Accounts Payable increased by $30. 2. June 29. The balance sheet account Merchandise Inventory decreased by $30, and Biwheels recorded a $30 cost of goods sold expense on the income statement. (Note that Biwheels would also record the sales revenue and increase either cash or accounts receivable on June 29, but we are focusing here on the expense part of the transaction.) At the end of June, no cash transaction had occurred. Neither purchasing inventory on credit nor charging cost of goods sold expense affects cash. The cash transaction occurs on July 7, when Biwheels pays $30 in cash to the supplier, thereby reducing its accounts payable by $30. The end result of the three transactions is a $30 expense and a $30 cash payment. However, Biwheels recorded the expense in June and the cash outflow in July. June’s income statement would have a $30 expense, but June’s cash flow statement would have no related cash outflow. In July, the situation would be reversed—the cash flow statement would have a $30 outflow, but there would be no expense on the income statement. Notice in Exhibit 5-5 that there is no effect on cash when we recognize cost of goods sold or purchase inventory on credit, but there is a decrease in cash when we pay accounts payable or purchase inventory for cash. Now that you know some of the operating transactions that affect cash and how the cash inflow or outflow can occur at a different time than the recording of the related revenue or expense, let’s examine the two formats used for showing the cash flow effects of operations.

Cash Flows from Operations—The Direct Method The direct method consists of a listing of cash receipts (inflows) and cash disbursements (outflows). The easiest way to identify cash flows from operations using the direct method is to examine the Cash column of the balance sheet equation. The following entries from Exhibit 5-2 (p. 193) affect cash: Entry

Cash Effect

(1) Initial investment

+400,000

(2) Loan from bank

+100,000

(3) Acquire store equipment for cash

–15,000

(4) Acquire inventory for cash

–120,000

(6) Acquire inventory for cash plus credit

–10,000

(7) Sale of equipment

+1,000

(9) Payment to creditor

–4,000

(11) Collect accounts receivable

+5,000

(12) Pay rent in advance

–6,000

We know from the previous sections that transactions 1 and 2 are financing activities and transactions 3 and 7 are investing activities. Thus, the remaining transactions affecting cash must be

 OBJECTIVE 5 Use the direct method to calculate cash flows from operations.

201

202

CHAPTER 5 • STATEMENT OF CASH FLOWS

operating activities. Therefore, the cash flows from operating activities must include transactions 4, 6, 9, 11, and 12, which are in bold italics. The statement follows: Biwheels Company Cash Flows from Operating Activities For the Month of January 20X2 Cash payments for inventory (transactions 4 and 6)

$(130,000)

Cash payments to creditors for accounts payable (transaction 9)

(4,000)

Cash collections on accounts receivable (transaction 11)

5,000 (6,000)

Cash payments for rent (transaction 12)

$(135,000)

Net cash used by operating activities

A more common format for this statement lists the cash collections first. It also combines the cash payments for inventory and cash payments to creditors for accounts payable on one line, cash payments to suppliers: Biwheels Company Cash Flows from Operating Activities For the Month of January 20X2 Cash collections Cash payments to suppliers Cash payments for rent Net cash used by operating activities

$

5,000

(134,000) (6,000) $(135,000)

Notice the small cash inflow generated by operations during January. All sales in January were credit sales, and Biwheels collected only $5,000 during the month. Operating cash outflows that exceed cash inflows are common in young, growing companies. Companies pay for items such as rent and inventories in advance of receiving cash for the sales that result from the use of these resources.

 OBJECT IVE 6 Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities.

Cash Flows from Operations—The Indirect Method The direct method gives a straightforward picture of where a company gets cash and how it spends cash. However, some users of financial statements may want to understand how the net cash flow from operating activities differ from net income. To show this, a company uses the indirect method. Let’s examine the January indirect-method cash flow statement for Biwheels shown in Exhibit 5-6. The statement starts with net income, adds or subtracts a series of adjustments, and ends with net cash provided by (used for) operating activities. To construct this statement, we use January’s income statement, the January 31 balance sheet from Exhibit 5-3 on p. 194, and the January 1 balance sheet where all accounts have a zero balance. Each income statement item has a related item or items in the statement of cash flows, although a transaction may appear on the two statements at different points in time. That is, each sale eventually results in cash inflows; each expense entails cash outflows at some time. However, a company often records a revenue in one accounting period and receives the related cash inflow in another. Similarly, it may record an expense in a period that differs from that in which it records the related cash outflow. The indirect method highlights the differences between (1) revenues and cash inflows, and (2) expenses and cash outflows in a given time period. Look again at Exhibit 5-6. If all sales were for cash and all expenses were paid in cash as incurred, cash flows from operating activities would be identical to net income. Thus, you can think of the first line of Exhibit 5-6, net income, as what the cash flow from operating activities would be if all revenues were cash inflows and all expenses were cash outflows. The subsequent adjustments recognize the differences in timing between revenues and cash inflows and between expenses and cash outflows. Understanding these adjustments is key to understanding the indirect method. An alternative format that can help you become familiar with these adjustments is in Exhibit 5-7, where the middle column contains the adjustments shown in Exhibit 5-6. We will describe Exhibit 5-7 as we discuss each adjustment.

203

CASH FLOWS FROM OPERATING ACTIVITIES

Net income

EXHIBIT 5-6 Biwheels Company

$ 57,900

Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation

Cash Flows from Operating Activities—Indirect Method, for the Month of January 20X2

100

Increase in accounts receivable

(155,000)

Increase in inventory

(59,200)

Increase in accounts payable

25,200 (4,000)

Increase in prepaid rent

$(135,000)

Net cash provided by (used for) operating activities

ADJUSTMENT FOR DEPRECIATION The first adjustment is to add depreciation expense back to net

income. We do this because we deducted depreciation of $100 when computing the net income of $57,900, but there is no related operating cash outflow in January. In fact, depreciation never entails an operating cash flow because the cash flow occurred as an investing activity when Biwheels paid for the equipment. Because we deducted $100 of depreciation in computing January’s net income, adding it back simply cancels the deduction. There is no cash flow effect of depreciation. A word of caution—do not interpret the $100 depreciation add-back as a cash inflow. While line items in the financing and investing sections of a statement of cash flows represent cash inflows and cash outflows, the line items in the operating section of an indirect method statement are not cash flows. Rather, they are adjustments of net income. An adjustment similar to the one made for depreciation will apply to any expense for which there is never an operating cash outflow. To highlight the effect of depreciation, let’s for a moment assume that Biwheels received all $160,000 of revenue in cash and paid all $102,000 of nondepreciation expenses in cash. The income statement and statement of cash flows from operating activities would be as follows: Income Statement

 OBJECTIVE 7 Understand why we add depreciation to net income when using the indirect method for computing cash flows from operating activities.

Cash Flows from Operating Activities

Sales

$ 160,000

Nondepreciation expenses

Cash inflows from sales

$160,000 (102,000)

(102,000) Cash outflows for expenses (100) Net cash provided by operating activities

Depreciation Net income

$ 58,000

$ 57,900

The only difference between net income and net cash provided by operating activities in this example is the $100 of depreciation. To compute the net cash provided by operating activities, we simply add the $100 to the net income: ($57,900 + $100) = $58,000. The center column of line D EXHIBIT 5-7 Biwheels Company Comparison of Net Income and Net Cash Provided by Operating Activities

A. Sales revenues

C. Rent expense D. Depreciation Net income

$160,000

(100,000) (2,000) (100) $ 57,900

*Depreciation is not a cash flow.

Increase in accounts receivable Increase in inventories Increase in accounts payable Increase in prepaid rent

˙˘¯

B. Cost of goods sold

Adjustments

Depreciation Total adjustments

Cash Flows from Operating Activities

$(155,000) (59,200)

¯˘˙

Net Income

25,200 (4,000)

100 $(192,900)

Cash collections from customers Cash payments to suppliers Cash payments for rent

$

5,000

(134,000) (6,000) 0*

Net cash provided by (used for) operating activities

$(135,000)

204

CHAPTER 5 • STATEMENT OF CASH FLOWS

of Exhibit 5-7 shows depreciation as one of the adjustments to net income when computing cash provided by operating activities. Now suppose depreciation expense was $500 rather than $100. Net income would be ($160,000 – $102,000 – $500) = $57,500, and net cash provided by operating activities would still be $58,000, the sum of net income ($57,500) and depreciation ($500). Net cash provided by operating activities did not change with the increase in depreciation. That is, the amount of depreciation has no effect on the cash provided by operating activities. To calculate cash flows, we add back to net income exactly the same amount we subtracted for depreciation, essentially canceling the earlier deduction. Depreciation is Biwheels’ only expense for which there is never an operating cash flow. The related cash flow was an investing outflow at the time the company paid for the underlying asset. The remaining adjustments for Biwheels represent situations where timing creates differences between net income and cash flows from operations. That is, over time the total revenue or expense will equal the total operating cash inflow or outflow, but the company may report some revenues or expenses on the income statement in one period and the related cash inflows or outflows on the statement of cash flows in another period. ADJUSTMENT FOR REVENUES Consider Biwheels’ revenues. If all of Biwheels’ sales were for

cash, there would be no accounts receivable, the associated cash flows would occur at the time of sale, and the cash inflow would equal the sales revenue. However, Biwheels’ January sales are all on open account. Thus, each sale initially increases accounts receivable, and the cash inflow occurs when Biwheels collects the receivable from the customer. You can compute the amount of cash collections from income statement and balance sheet data in two steps: (1) compute the total amount Biwheels could possibly collect in the month, which is the sales for the month plus the accounts receivable balance at the beginning of the month, and (2) from this you subtract the amount that Biwheels has not yet collected, the accounts receivable at the end of the month. This gives collections in January of $5,000: Sales

$160,000 0

+ Beginning accounts receivable Potential collections

160,000

– Ending accounts receivable

155,000

Cash collections from customers

$

5,000

We can simplify this by subtracting the ending accounts receivable balance from the beginning accounts receivables balance to give us a single number representing the change in accounts receivable. Beginning accounts receivable

$

155,000

Less: Ending accounts receivable Decrease (increase) in accounts receivable

0

$(155,000)

Don’t be fooled by the signs. When the number is negative, accounts receivable has increased. When the number is positive, accounts receivable has decreased. Combining the change in accounts receivable with sales gives us the amount of cash collected from customers during the period: Sales

$160,000

Decrease (increase) in accounts receivable*

(155,000)

Cash collections from customers

$

5,000

*The format “decrease (increase)” means that decreases are positive amounts and increases are negative amounts.

In the Biwheels example, accounts receivable increased by $155,000, meaning that collections from customers fell short of sales. So net income was overstated relative to the amount

CASH FLOWS FROM OPERATING ACTIVITIES

205

of operating cash flows received. Because Biwheels’ accounts receivable increased in January, we deduct the $155,000 from net income to get cash provided by operating activities. Line A in Exhibit 5-7 shows this adjustment. If accounts receivable had remained unchanged (that is, accounts receivable at the end of the month equaled the accounts receivable at the beginning of the month), cash collections would equal sales and no adjustment of net income would be necessary. If accounts receivable had decreased, meaning that collections exceeded sales, net income would be lower than cash flows from operations. We would then add the decrease in accounts receivable to sales to determine the cash collections.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Suppose all $160,000 of Biwheels’ sales were for cash. Compute the cash collections from customers using the formula sales plus or minus the change in accounts receivable. Explain.

receivable, there would be no adjustment of sales needed to compute cash collections from customers:

Sales

$160,000

Answer

Decrease (increase) in accounts receivable

If all sales were for cash, accounts receivable would have remained at $0. Because there was no increase or decrease in accounts

Cash collections from customers

ADJUSTMENT FOR COST OF GOODS SOLD Just as we adjusted sales to compute cash collections from customers, we can adjust cost of goods sold to compute cash outflow for payments to suppliers. To do this, we use one income statement account, Cost of Goods Sold, and two balance sheet accounts, Inventory and Accounts Payable. We adjust cost of goods sold to get cash payments to suppliers in two steps:

Cost of Goods Sold

2. Adjusted to Get

1. Adjusted to Get Purchases

Payments to Suppliers

These two steps yield the following: Step 1 Cost of goods sold in January

$100,000

+ Ending inventory, January 31

59,200

Inventory available in January

159,200

– Beginning inventory, January 1 Inventory purchased in January

0 $159,200

Step 2 Inventory purchased in January + Beginning accounts payable, January 1 Total amount to be paid – Ending accounts payable, January 31 Amount paid in cash during January

$159,200 0 159,200 (25,200) $134,000

In step 1, we compute the amount of inventory purchased in January, independent of whether we purchase the inventory for cash or credit. This requires two calculations: (1) adding the amount of inventory used in January (that is, the cost of goods sold) to the amount of inventory left at the end of January to get the total inventory available in January, and (2) deducting from that total the amount that was in inventory at the beginning of the month. This yields the

0 $160,000

206

CHAPTER 5 • STATEMENT OF CASH FLOWS

total inventory purchased in January. It is important to understand that, in the Biwheels example, the beginning inventory balance was zero, so purchases and inventory available in January both equal $159,200. When a company has been in operation for multiple periods, this equality is unlikely. If Biwheels had bought all of its inventory for cash, we could stop at this point. Its cash outflow to suppliers would equal the amount purchased, $159,200. However, because Biwheels purchased some inventory on credit, we must take step 2. This requires examining the activity in Biwheels’ accounts payable as well as activity in inventory. If Biwheels had paid off all its accounts payable by the end of January, it would have paid an amount equal to the beginning accounts payable plus the purchases in January, a total of $159,200. Yet, $25,200 remained payable at the end of January, meaning that of the $159,200 of potential payments, Biwheels paid only ($159,200 – $25,200) = $134,000 in January. As with the adjustment for revenues, we can simplify these two steps into one line each: Cost of goods sold in January Step 1: Increase (decrease) in inventory during January Step 2: Decrease (increase) in accounts payable during January Payments to suppliers during January

$100,000 59,200 (25,200) $134,000

The first two lines show that Biwheels purchased $159,200 of inventory—$100,000 to meet sales demand and $59,200 to build up inventory. If all purchases were for cash, the payments to suppliers would have been $159,200. (If inventory had decreased during the month, the amount of purchases would be cost of goods sold minus the decrease in inventory.) However, because accounts payable increased by $25,200, Biwheels did not pay the entire $159,200 in January. Of the $159,200 potential cash outflow, Biwheels will pay $25,200 sometime after January, so the company paid only ($159,200 – $25,200) = $134,000 in January. These adjustments that convert cost of goods sold into payments to suppliers are shown in line B of Exhibit 5-7. Because an increase in inventories requires extra cash, the cash flow from operations will be less than net income—that is, we subtract the $59,200 increase in inventories from net income when computing cash flows from operations. In contrast, when accounts payable increases we retain cash that accounting period, so we add the $25,200 increase in accounts payable to net income when computing cash flows from operations. ADJUSTMENTS FOR OTHER EXPENSES Before considering line C in Exhibit 5-7, let’s create a general approach to adjustments. Then we can apply the approach to line C.

• Adjust for revenues and expenses that do not require cash: Add back depreciation. Add back other expenses that do not require cash. Deduct revenues that do not generate cash. • Adjust for changes in noncash assets and liabilities relating to operating activities: Add decreases in operating assets. Deduct increases in operating assets. Add increases in operating liabilities. Deduct decreases in operating liabilities. Adjustments so far have included adding back the $100 of depreciation expense, deducting the $155,000 increase in accounts receivable (an operating asset), deducting the $59,200 increase in inventory (an operating asset), and adding the $25,200 increase in accounts payable (an operating liability). Take time to verify that each of these adjustments is consistent with the preceding general rules. We will see other adjustments similar to depreciation in later chapters. Now let’s consider Biwheels’ adjustments for its other operating assets and liabilities. The only such asset or liability is Prepaid Rent, an asset account. It increased from $0 at the beginning of the month to $4,000 at the end of the month. Thus, we need to deduct $4,000 from net income to compute cash flow from operations, as shown in line C of Exhibit 5-7. This $4,000 adjustment is the result of paying $6,000 in cash for rent, but charging only $2,000

THE STATEMENT OF CASH FLOWS AND THE BALANCE SHEET EQUATION

207

as an expense. This means that Biwheels’ cash outflow for rent exceeded the rent expense by $4,000 in the month of January. To summarize, look again at Exhibit 5-7. An indirect-method cash flow statement begins with the net income of $57,900 from the bottom of the first column of Exhibit 5-7, adds (deducts) the adjustments totaling $(192,900) in the middle column, and ends with the $(135,000) net cash used for operating activities in the right-hand column. The left-hand column calculates net income, the right-hand column calculates cash flows from operations, and the middle column shows line-by-line adjustments that represent all the differences between net income and cash flow from operations. Although Biwheels had a healthy net income of $57,900, it used $135,000 of cash to support its operations. Such a depletion of cash cannot continue indefinitely, regardless of how much income Biwheels generates. However, Biwheels is like other young, growing companies: It is using cash to build up its business in anticipation of positive cash flows being provided by operating activities in the future.

Reconciliation Statement When a company uses the direct method for reporting cash flows from operating activities, users of the financial statements might miss information that relates net income to operating cash flows. Thus, those using direct-method statements must include a supplementary schedule reconciling net income to net cash provided by operations. Such a supplementary statement is effectively the operating section of an indirect method cash flow statement. In essence, companies that choose to use the direct method must also report using the indirect method. In contrast, those using the indirect method never explicitly report the information on a direct-method statement. The supplementary statement included with direct-method cash flow statements would be identical to the body of Exhibit 5-6, but it would be labeled “Reconciliation of Net Income to Net Cash Provided by Operating Activities.”

The Statement of Cash Flows and the Balance Sheet Equation To better understand how the cash flow statement relates to the other financial statements, let’s examine the balance sheet equation. The balance sheet equation provides the conceptual basis for all financial statements, including the statement of cash flows. The equation can be rearranged as follows: Assets = Liabilities + Stockholders> equity

Cash + Noncash assets 1NCA2 = L

+ SE

Cash = L

+ SE

- NCA

Any change (Δ) in cash must be accompanied by a change in one or more items on the right side to keep the equation in balance: ⌬Cash = ⌬L + ⌬SE - ⌬NCA Therefore: Change in cash = Change in all noncash accounts or What happened to cash = Why it happened The statement of cash flows focuses on the changes in the noncash accounts as a way of explaining how and why the amount of cash has increased or decreased during a given period. Thus, changes in the accounts on the right side of the equation appear in the statement of cash flows when they involve the use or receipt of cash. The left side of the equation measures the net effect of the change in cash. Of course, transactions can occur that affect only the right side of the

 OBJECTIVE 8 Show how the balance sheet equation provides a conceptual framework for the statement of cash flows.

208

EXHIBIT 5-8 Biwheels Company Analysis of Operating Transactions for January 20X2 (in $)

Description of Transactions (4) (5) (6) (8) (9) (10a) (10b) (11) (12) (13) (14)

Acquire inventory for cash Acquire inventory on credit Acquire inventory for cash plus credit Return of inventory acquired on January 6 Payment to creditor Sales on open account Cost of merchandise inventory sold Collect accounts receivable Pay rent in advance Recognize expiration of rental services Depreciation

Total Changes

Cash

=

Liabilities

+

Cash

=

Accounts Payable

+

–120,000 = = –10,000 = = –4,000 = = = +5,000 = –6,000 = = –135,000 =

Stockholders’ Equity Retained Earnings





Noncash Assets Accounts Receivable



Merchandise Inventory



Prepaid Rent



Store Equipment

+120,000 +10,000 +30,000

+10,000 +20,000 –800 –4,000

–800 +160,000 –100,000

+160,000 –100,000 –5,000 +6,000 –2,000

–2,000 –100 +25,200

+

+57,900

–100 –

+155,000



+59,200



+4,000



–100

EXAMPLES OF STATEMENTS OF CASH FLOWS

equation. For example, the purchase of equipment in exchange for common stock is a noncash investing and financing activity. Remember that such activities do not affect cash and do not appear in the statement of cash flows. This same analysis can help explain the direct and indirect methods of reporting cash from operating activities. Exhibit 5-8 lists all of Biwheels’ January transactions that we classify as operating activities. However, we have rearranged the columns in the format of the revised balance sheet equation presented above: ⌬Cash = ⌬L + ⌬SE - ⌬NCA. We list only the transactions that appear in the operating cash flows section of the statement of cash flows. Recall that operating activities are transactions that affect the purchase, processing, and selling of products or services. Notice that the entries on the left side of the equal signs (those in the boxes) appear on the direct-method statement of cash flows from operations. They are the direct cash flows and total an outflow of $135,000. The changes in each account (that is, the bottom line for each column) on the right side of the equation (those circled) appear on the indirect-method statement. They also must total $135,000. Therefore, you can see that the direct- and indirect-method statements must always produce the same amount of net cash flow from operations. They differ only in format. The direct-method statement is a listing of all changes in cash, whereas the indirect-method statement shows the reasons for those changes. The following summarizes this analysis: ⌬Cash = ⌬L + ⌬SE - ⌬NCA Direct method = Indirect method

Examples of Statements of Cash Flows Exhibit 5-9 shows the complete January indirect-method statement of cash flows for Biwheels. It shows that the total cash balance increased by $351,000, mainly due to $500,000 generated by financing activities. Of the $500,000 raised, operations used $135,000 and investing activities used $14,000, leaving the $351,000 balance.

EXHIBIT 5-9 Biwheels Company

Cash Flows from Operating Activities Net income Adjustments to reconcile net income to net cash provided by (used for) operating activities Depreciation Increase in accounts receivable Increase in inventory Increase in accounts payable Increase in prepaid rent

$ 57,900

Statement of Cash Flows For January 20X2

100 (155,000) (59,200) 25,200 (4,000)

Net cash provided by (used for) operating activities

$(135,000)

Cash Flows from Investing Activities Purchase of store equipment Proceeds from sale of store equipment Net cash provided by (used for) investing activities

$ (15,000) 1,000 (14,000)

Cash Flows from Financing Activities Proceeds from initial investment Proceeds from bank loan Net cash provided by (used for) financing activities Net increase in cash Cash, January 2, 20X2 Cash, January 31, 20X2

$400,000 100,000 500,000 351,000 0 $ 351,000

209

210

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EXHIBIT 5-10 Costco, Inc. Statement of Cash Flows (in millions), for the Year Ended August 28, 2011

CASH PROVIDED (USED) BY OPERATIONS Net income Adjustments to reconcile net income to net cash provided by operating activities: Income charges not affecting cash Depreciation Other noncash charges Changes in operating assets and liabilities: Increase in merchandise inventories Increase in accounts payable Other operating assets and liabilities, net

$ 1,542

855 269 (642) 804 370

Net cash provided by operating activities

$ 3,198

CASH PROVIDED (USED) BY INVESTING ACTIVITIES Purchases of short-term investments Maturities of short-term investments Sales of investments Additions to property and equipment Proceeds from the sale of property and equipment Other investing activities, net Cash used by investing activities

(3,276) 2,614 602 (1,290) 16 154 (1,180)

CASH PROVIDED (USED) BY FINANCING ACTIVITIES Repayments of short-term borrowings Proceeds from short-term borrowings Cash dividend payments Repurchases of common stock Other financing activities, net Cash used by financing activities Effect of exchange rate changes Net increase in cash and equivalents Cash and equivalents, beginning of year Cash and equivalents, end of year

(105) 79 (389) (624) (238) (1,277) 54 795 3,214 $ 4,009

You are now prepared to read most of the significant items on a real corporation’s statement of cash flows. Consider Exhibit 5-10, Costco’s statement of cash flows. We have simplified some items that were not covered in this chapter, but most of the items included should be familiar. Some terminology is slightly different from what we have used, but the meanings should be clear. Notice that Costco did almost the opposite of Biwheels. It generated substantial cash from operations and used that cash for both investing and financing activities.

Summary Problem for Your Review PROBLEM Examine the entries to Biwheels’ balance sheet equation for February 20X2 in Exhibit 2-5 (p. 60) and the balance sheet and income statement in Exhibits 2-6 and 2-7 (p. 61). 1. Prepare a statement of cash flows from operating activities for February using the direct method. 2. Prepare a statement of cash flows from operating activities for February using the indirect method. 3. Give a one-line explanation of the insight most readily learned from each of the two statements.

THE IMPORTANCE OF CASH FLOW

211

SOLUTION 1. See Exhibit 5-11. The numbers come directly from the first column of Exhibit  2-5. The cash collections are $130,000 collected on accounts receivable and the $51,000 cash sales. The payments to suppliers include $15,000 paid on accounts payable and $10,000 for cash purchases. 2. See Exhibit 5-12. The net income and add-back of depreciation come from the income statement. The other adjustments are differences between January 31 and February 28 balances on the balance sheets. 3. The direct-method statement shows the large excess of cash collections over cash payments. The indirect-method statement shows that the net cash flow from operations exceeded net income by ($156,000 – $63,900) = $92,100 due primarily to the large increase in accounts payable and the depletion of inventory.

Cash collections from customers Cash payments to suppliers Net cash provided by operating activities

Net income Adjustments to reconcile net income to net cash provided by (used for) operating activities Depreciation Decrease in accounts receivable Decrease in inventory Increase in accounts payable Decrease in prepaid rent Net cash provided by (used for) operating activities

$181,000 (25,000) $156,000

$ 63,900

100 5,000

EXHIBIT 5-11 Biwheels Company Statement of Cash Flows from Operating Activities— Direct Method, February 20X2

EXHIBIT 5-12 Biwheels Company Statement of Cash Flows from Operating Activities— Indirect Method, February 20X2

20,000 65,000 2,000 $156,000

The Importance of Cash Flow Both the income statement and the statement of cash flows report on changes the company expeOBJECTIVE 9 riences during the period. Both are measures of performance over the period. You might wonder Identify free cash flow, and why accounting authorities require both. Because each one provides important, but different, interpret information in the information. The income statement shows how stockholders’ equity increases (or decreases) as statement of cash flows. a result of operations. It matches revenues and expenses using the accrual concepts and provides a valuable measure of economic performance. In contrast, the statement of cash flows explains changes in the cash account rather than changes in owners’ equity. The focal point of the statement of cash flows is the net cash flow from operating activities, often called simply cash flow. It  measures a firm’s performance in maintaining a strong cash position. In addition, users of financial statements often compare the cash flows from operating, investing, and financing activities. The Business First box on p. 212 describes some of these comparisons. Many analysts focus on free cash flow—generally defined as net cash flow from operations free cash flow less capital expenditures. This is the cash flow remaining after undertaking the firm’s operations Generally defined as net cash and making the investments necessary to ensure its continued operation. Some also subtract divi- flow from operations less capital dends, assuming they are necessary to keep the shareholders happy. Companies that cannot gen- expenditures. erate enough cash from operations to cover their investments need to raise more capital, either by selling assets or by issuing debt or equity. If investment is for growth, this situation may be acceptable. Wal-Mart had negative free cash flow for years as it built up its business. However, if the investment is merely to maintain the status quo, the company is probably in trouble. In the

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CHAPTER 5 • STATEMENT OF CASH FLOWS

BUSINESS FIRST I N T E R P R E T I N G O P E R AT I N G , I N V E S T I N G , AND FINANCING CASH FLOWS Comparing net cash flow from operations with the net cash flow from investing and financing activities can tell a lot about a company. First, let’s consider companies with positive net cash flow from operations. Those who have negative net cash flow from investing activities in the same period, that is, those who used funds to expand their investments in fixed assets, tend to be healthy, growing firms. In the early years these firms often have positive net cash flow from financing activities as the result of raising capital in the debt or equity markets. As they mature, the most successful of these companies begin to pay back debt and return capital to shareholders, making net cash flow from financing activities negative. For example, in the last two decades Starbucks has had consistently positive net cash flow from operations and negative net cash flow from investing activities as it expanded its operations globally. Until 2003 Starbucks generally raised capital, creating positive net cash flow from financing activities. Since 2003 Starbucks has used cash for financing activities, paying back debt holders and shareholders. If companies with positive net cash flow from operations also have positive net cash flow from investing activities, analysts often question the company’s future prospects. Such companies are depleting their asset bases, so they are not preparing for future growth. For example, Aquila Corporation, in the 2 years before its 2008 purchase by Great Plains Energy, reported $212 million net cash provided by operations and $786 million net cash provided by investing activities. Although operations were generating cash, Aquila needed to sell assets to generate additional cash to pay debts as they came due. The cash flow problems that necessitated Aquila’s selling

of assets were a main reason the shareholders approved the company’s sale to Great Plains. Companies with negative net cash flow from operations are generally in one of two categories: (1) young companies that have not yet reached the point of generating positive operating net cash flows, and (2)  companies that are in trouble. In the first category are many biotechnology companies that must undertake years of R&D before having salable products. Pressure Biosciences, Inc., a Boston life-sciences company, is an example of a company that has not had positive operating net cash flow but continues to raise capital and invest in additional fixed assets. If such companies do not have positive net cash from financing activities, analysts examine whether their existing cash is likely to be enough to cover negative operating and investing cash flows long enough to reach profitability. Medivir AB, a Swedish biotech company, was in the same situation as Pressure Biosciences until 2011 when it achieved its first positive net cash flow from operations. Companies with negative net cash flow from operations and positive net cash flow from investing activities are, either intentionally or unwittingly, liquidating the company. They are selling off their assets to support money-losing operating activities. Midway Games, the Chicago-based entertainment software company that published video games such as the Mortal Kombat series and NBA Jam, had such a situation in 2008, just prior to its 2009 bankruptcy filing.

Sources: Medivir AB 2011 Annual Report; Pressure Biosciences, Inc. 2010 Annual Report; Starbucks 2011 Annual Report; Midway Games 2008 Annual Report; W. Wong, “Midway Games, Known for Mortal Kombat, Files for Chapter 11,” Chicago Tribune (February 12, 2009).

recession of 2008–2011, numerous companies experienced negative free cash flow, and many resorted to selling off assets to meet their cash needs. Examples of companies with negative free cash flow are AMR Corp., parent of American Airlines, which experienced negative free cash flow for 3 years before its bankruptcy declaration in November 2011, and Dynegy, Inc., the $2.3 billion electric energy company, which experienced negative free cash flow in 4 of the 5 years before its bankruptcy, also in November 2011. Biwheels Company has a large negative free cash flow for January, [$(135,000) – $15,000] = $(150,000), meaning that it must improve its net cash flow from operations or it will need to raise additional capital. In February its free cash flow improved to a positive ($156,000 – $10,000) = $146,000.

The Crisis of Negative Cash Flow Although investors make important economic decisions on the basis of net income, the so-called bottom line, sometimes earnings numbers do not tell the full story of what is really happening inside a company. Take the classic case of Prime Motor Inns, once one of the world’s largest

THE IMPORTANCE OF CASH FLOW

213

hotel operators. At its peak, Prime reported earnings of $77 million on revenues of $410 million. Moreover, revenues had increased by nearly 11% from the preceding year. Despite its impressive earnings performance, Prime lacked the cash to meet its obligations and filed for Chapter 11 bankruptcy. Under bankruptcy protection, a firm’s obligations to its creditors are frozen as management figures out how to pay those creditors. How can a firm with $77 million in earnings file for bankruptcy about a year later? Although the company’s business was owning and operating hotels, much of Prime’s reported $77 million of earnings arose from selling hotels. When buyers found it difficult to obtain outside financing for these hotel sales, Prime financed the sales itself by accepting notes and mortgages receivable from buyers rather than receiving cash. Of course, Prime soon ran out of hotels to sell. In the year that Prime reported $77 million of net income, an astute analyst would have noted that Prime had a net cash outflow from operations of $15 million. The cash flow statement can provide insights that are not evident from the income statement alone.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S What pattern in the cash flow statement would have helped to alert the careful analyst to a potential problem at Prime Motor Inns?

accepting notes and mortgages from buyers. This predicament would have been evident from the significant increases in these notes and mortgages receivable as compared with prior years.

Answer Prime was reporting large profits under accrual accounting, but operating cash flow was negative. Prime was financing sales by

Summary Problems for Your Review PROBLEM The Buretta Company uses U.S. GAAP and has prepared the data in Exhibit 5-13. In December 20X2, Buretta paid $54 million cash for a new building acquired to accommodate an expansion of operations. The company financed this purchase partly by a new issue of long-term debt for $40 million cash. During 20X2, the company also sold fixed assets for $5 million cash. The assets were listed on Buretta’s books at $5 million. All sales and purchases of merchandise were on credit. Because the 20X2 net income of $4 million was the highest in the company’s history, Alice Buretta, the company’s president, was perplexed by the company’s extremely low cash balance. 1. Prepare a statement of cash flows from the Buretta data in Exhibit 5-13. Ignore income taxes. Use the direct method for reporting cash flows from operating activities. 2. Prepare a supporting schedule that reconciles net income to net cash provided by operating activities. 3. What does the statement of cash flows tell you about Buretta Company? Does it help you reduce Alice Buretta’s puzzlement? Why?

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CHAPTER 5 • STATEMENT OF CASH FLOWS

EXHIBIT 5-13 Buretta Company Financial Statements (in millions) Income Statement (Including Changes in Retained Earnings) For the Year Ended December 31, 20X2 Sales

$100

Less: Cost of goods sold Inventory, December 31, 20X1

$ 15

Purchases

105

Cost of goods available for sale

120

Inventory, December 31, 20X2

(47)

73 27

Gross profit Less: Other expenses General expenses

8

Depreciation

8

Property taxes

4

Interest expense

3

23 4

Net income Retained earnings, December 31, 20X1

7

Subtotal

11

Dividends declared and paid

1

Retained earnings, December 31, 20X2

$ 10

Balance Sheets for December 31 Assets

Liabilities and Stockholders’ Equity 20X2

Cash Accounts receivable Inventory Prepaid general expenses Fixed assets, net

$

1

Total assets

$162

20 47 3 91

20X1 $20 5 15

20X2

20X1

Accounts payable

$ 39

$14

Accrued property tax payable Long-term debt Common stock

3 40 70

1 0 70

10

7

$162

$92

2 50 Retained earnings Total liabilities and $92 stockholders’ equity

THE IMPORTANCE OF CASH FLOW

215

SOLUTION 1. See Exhibit 5-14. We can compute cash flows from operating activities as follows ($ in millions): Sales Less increase in accounts receivable (a) Cash collections from customers Cost of goods sold Plus increase in inventory Purchases Less: Increase in accounts payable (b) Cash paid to suppliers General expenses Plus increase in prepaid general expenses (c) Cash payment for general expenses (d) Cash paid for interest Property taxes Less: Increase in accrued property tax payable (e) Cash paid for property taxes

$100 (15) $ 85 $ 73 32 105 (25) $ 80 $ 8 1 $ 9 $ 3 $ 4 (2) $ 2

2. Exhibit 5-15 reconciles net income to net cash used by operating activities. 3. The statement of cash flows shows where cash has come from and where it has gone. Operations used $9 million of cash. Why? The statement in Exhibit 5-14, which uses the direct method, shows the result clearly: $94 million in cash paid for operating activities exceeded $85 million in cash received from customers. The reconciliation using the indirect method, in Exhibit 5-15, shows why, in a profitable year, operating cash flow could be negative. The three largest items that explain the difference in net income and net cash flow from operations are changes in inventory, accounts receivable, and accounts payable. Sales during the period were not collected in full because accounts receivable rose sharply, by $15 million—a 300% increase. Similarly, Buretta spent cash on inventory growth, although it financed much of that growth by increased accounts payable. In summary, the items

Cash flows from operating activities Cash collections from customers (a) Cash payments Cash paid to suppliers (b) General expenses (c) Interest paid (d) Property taxes (e) Net cash used by operating activities Cash flows from investing activities Purchase of fixed assets (building) Proceeds from sale of fixed assets Net cash used by investing activities Cash flows from financing activities Long-term debt issued Dividends paid Net cash provided by financing activities Net decrease in cash Cash balance, December 31, 20X1 Cash balance, December 31, 20X2

$ 85 $(80) (9) (3) (2)

(94) (9)

(54) 5 (49) 40 (1) 39 (19) 20 $ 1

EXHIBIT 5-14 Buretta Company Statement of Cash Flows, for the Year Ended December 31, 20X2 (in millions)

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CHAPTER 5 • STATEMENT OF CASH FLOWS

EXHIBIT 5-15 Supporting Schedule to Statement of Cash Flows Reconciliation of Net Income to Net Cash Used by Operating Activities, for the Year Ended December 31, 20X2 (in millions) Net income (from income statement) Adjustments to reconcile net income to net cash used by operating activities: Add: Depreciation, which was deducted in the computation of net income but does not decrease cash Deduct: Increase in accounts receivable Deduct: Increase in inventory Deduct: Increase in prepaid general expenses Add: Increase in accounts payable Add: Increase in accrued property tax payable Net cash used by operating activities

$ 4

8 (15) (32) (1) 25 2 $ (9)

in parentheses in Exhibit  5-15, large increases in accounts receivable ($15 million) and inventory ($32 million), plus an increase in prepaid expenses ($1 million), show that Buretta used $48 million of cash in operations. In contrast, the sum of the items not in parentheses shows that Buretta generated only $39 million in cash from operations, that is, ($4 million + $8 million + $25 million + $2 million). Thus, the company used a net amount of $9 million in operations ($39 million – $48 million). Investing activities also consumed cash because Buretta invested $54 million in a building, and it received only $5 million from sales of fixed assets, leaving a net use of $49  million. Financing activities did generate $39 million cash, but that was $19 million less than the $58  million used by operating and investing activities ($9 million used in operations  + $49 million used in investing). Alice Buretta should no longer be puzzled by the reduction in cash. The statement of cash flows shows clearly that cash payments exceeded receipts by $19 million. However, she may still be concerned about the depletion of cash. Either the company must change operations so it does not require so much cash, it must curtail investment, or it must raise more long-term debt or ownership equity. Otherwise, Buretta Company will soon run out of cash.

PROBLEM To understand how cash flow and net income vary during the life cycle of a business, consider the following example that portrays the 4-year life of a short-lived merchandising company, CB International. The first year the entrepreneurs bought twice as much as they sold because they were building their base inventory levels. CB International’s suppliers offered payment terms that resulted in CB paying 80% of each year’s purchases during that year and 20% in the next year. Sales were for cash with a sales price equal to twice the cost of the item. Selling expenses were constant over the life of the business, and CB International paid them in cash as incurred. At the end of the fourth year, CB International paid the suppliers in full and sold all the inventory. Use the following summary results to prepare four income statements and statements of cash flows from operations using both direct and indirect methods for CB International, one for each year of its life.

THE IMPORTANCE OF CASH FLOW

Year 1 Purchases $1 each Sales $2 each Cost of sales Selling expense Payments to suppliers*

Year 2

Year 3

Year 4

2,000 units $2,000 1,000 units $2,000 $1,000 $1,000

1,500 units $1,500 1,500 units $3,000 $1,500 $1,000

1,500 units $1,500 2,000 units $4,000 $2,000 $1,000

1,000 units $1,000 1,500 units $3,000 $1,500 $1,000

$1,600

$1,600

$1,500

$1,300

*(.8 × $2,000) = $1,600; (.2 × $2,000) + (.8 × $1,500) = $1,600; (.2 × $1,500) + (.8 × $1,500) = $1,500; (.2 × $1,500) + (1.0 × $1,000) = $1,300.

SOLUTION Year 1

Year 2

Year 3

Year 4

Total

$2,000

$3,000

$4,000

$3,000

$12,000

1,000 1,000 $ 0

1,500 1,000 $ 500

2,000 1,000 $1,000

1,500 1,000 $ 500

6,000 4,000 $ 2,000

$2,000 (1,600)

$3,000 (1,600)

$4,000 (1,500)

$3,000 (1,300)

$12,000 (6,000)

(1,000) $ (600)

(1,000) $ 400

(1,000) $1,500

(1,000) $ 700

(4,000) $ 2,000

$ 0 (1,000)

$ 500

$1,000

$ 500

500

500

$ 2,000 (1,000) 1,000 400

Income statement Sales Cost of sales Selling expenses Net income Cash flows from operations: direct method Collections from customers Payments to suppliers Payments for selling efforts Net cash flow from operations Cash flows from operations: indirect method Net income – Increase in inventory + Decrease in inventory + Increase in accounts payable – Decrease in accounts payable Cash flow from operations

400 $ (600)

(100) $ 400

$1,500

(300) $ 700

(400) $ 2,000

Balance Sheet Accounts at the end of

Year 1

Year 2

Year 3

Year 4

Merchandise inventory

$1,000

$1,000

$500

$0

Accounts payable

$ 400

$ 300

$300

0

This problem illustrates the difference between accrual-based earnings and cash flows. Significant cash outflows occur for operations during the first year because payments to acquire inventory and for selling expenses exceed collections from customers. In fact, it is not until the third year that net cash flow from operations exceeds net earnings for the year.

217

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Highlights to Remember

1

Identify the purposes of the statement of cash flows. The statement of cash flows focuses on the changes in cash and the activities that cause those changes. Accrual-based net income is a useful number, but we also ask the following questions: How did our cash position change? How much of the change in cash was caused by operations, how much by investing activities, and how much by financing activities? Classify activities affecting cash as operating, investing, or financing activities. Operating activities are the typical day-to-day activities of the firm in acquiring or manufacturing products, selling them to customers, and collecting the cash. Investing activities involve buying and selling plant, property, and equipment or other long-lived productive assets, as well as buying and selling securities that are not classified as cash equivalents. It might include buying a whole company as well as specific assets. Financing activities involve raising or repaying capital such as borrowing from a bank, issuing bonds, repaying debt, or paying dividends to shareholders. Compute and interpret cash flows from financing activities. Financing activities are transactions that obtain or repay capital. Cash flows from financing activities show whether a company borrows or repays money, issues additional securities, pays dividends, or buys back shares from stockholders. Compute and interpret cash flows from investing activities. Investing activities are transactions that acquire or sell long-lived productive assets such as property or equipment and securities held for investment purposes that are not considered cash equivalents. Cash flows from investing activities show where management has elected to invest any funds raised or generated. Use the direct method to calculate cash flows from operations. The direct method, preferred by the FASB and IASB, explicitly lists all cash inflows and cash outflows from operating activities. We can find the relevant cash flows in the cash column in the balance sheet equation. The advantage of the direct method is that it is straightforward and easy to understand. Use the indirect method to explain the difference between net income and net cash provided by (used for) operating activities. The more commonly used method for calculating the net cash flow from operations is the indirect method, which starts with net income and adjusts it for the differences, typically account by account, between accrual net income and operating cash flow. Both the direct and indirect method yield the same net cash flow from operations; the only difference is the format of the presentation. The advantage of the indirect method is that it explicitly addresses the differences between net income and net cash from operations. Understand why we add depreciation to net income when using the indirect method for computing cash flows from operating activities. Under the indirect method, we add depreciation expense back to net income because it is an expense that does not require the use of cash. Because we deduct depreciation when computing net income, adding it back simply eliminates the effect of deducting this noncash item. This adding back of depreciation expense sometimes causes some people to think of depreciation as a source of cash. This is not the case. Increasing depreciation does not affect cash flow. Show how the balance sheet equation provides a conceptual framework for the statement of cash flows. The balance sheet equation is the conceptual base of all financial statements. By reconstructing the equation with cash isolated on the left side of the equal sign, we can see how the right-hand entries provide an explanation for the changes in cash. Increases in liabilities or stockholders’ equity or decreases in noncash assets increase cash, whereas decreases in liabilities or stockholders’ equity or increases in noncash assets decrease cash. Identify free cash flow, and interpret information in the statement of cash flows. To understand how a company manages its cash, analysts often compare cash flows across operating, investing, and financing activities. Free cash flow, net cash flow from operations less capital expenditures and possibly dividends, is a metric that helps such comparisons.

2 3 4 5 6 7 8 9

ASSIGNMENT MATERIAL

Accounting Vocabulary bankruptcy, p. 189 cash equivalents, p. 190 cash flow statement, p. 189 cash flows from financing activities, p. 190

cash flows from investing activities, p. 191 cash flows from operating activities, p. 190 direct method, p. 199 financing activities, p. 191

free cash flow, p. 211 indirect method, p. 199 investing activities, p. 191 operating activities, p. 190 statement of cash flows, p. 189

Assignment Material Note: Many of the questions, exercises, and problems do not require the use of the indirect method of reporting cash flow from operations. The following can be answered by reading only pages 188–202: Questions 5-1 through 5-17, Exercises 5-33 through 5-40, and problems 5-48 through 5-56. Questions 5-1 “The statement of cash flows is an optional statement included by most companies in their annual reports.” Do you agree? Explain. 5-2 What are the purposes of a statement of cash flows? 5-3 Define cash equivalents. 5-4 The statement of cash flows summarizes what three types of activities? 5-5 Name four major operating activities included in a statement of cash flows. 5-6 Name three major investing activities included in a statement of cash flows. 5-7 Name three major financing activities included in a statement of cash flows. 5-8 There is one item on a cash flow statement that is not a cash flow but affects cash. What is it and why do companies include it on their statements of cash flow? 5-9 Where does interest received or paid appear on the statement of cash flows under U.S. GAAP? Under IFRS? 5-10 Which of the following financing activities increase cash: increase long-term debt, repurchase common shares, or pay dividends? Which decrease cash? 5-11 Which of the following investing activities increase cash: purchase fixed assets by issuing debt, sell fixed assets for cash, collect a loan, or purchase equipment for cash? Which decrease cash? 5-12 Explain why increases in liabilities increase cash and increases in noncash assets decrease cash.

5-13 Why are noncash investing and financing activities listed on a separate schedule accompanying the statement of cash flows? 5-14 A company acquired a fixed asset in exchange for common stock. Explain how this transaction should be shown, if at all, in the statement of cash flows. Why is your suggested treatment appropriate? 5-15 Suppose a company paid off a $1 million short-term loan to one bank with the proceeds from an identical loan from another bank. The change in the short-term debt account would be zero. Should anything appear in the statement of cash flows? Explain. 5-16 What are the two major ways of computing net cash provided by operating activities? 5-17 Where does a company get the information included in the direct-method cash flow statement? 5-18 Why is there usually a difference between the cash collections from customers and sales revenue in a period’s financial statements? 5-19 What two balance sheet accounts explain the difference between the cost of goods sold and the cash payments to suppliers? 5-20 What types of adjustments reconcile net income with net cash provided by operations? 5-21 “Net losses mean drains on cash.” Do you agree? Explain. 5-22 The indirect method for reporting cash flows from operating activities can create an erroneous impression about noncash expenses (such as depreciation). What is the impression, and why is it erroneous? 5-23 An investor’s newsletter had the following item: “The company expects increased cash flow in 2013 because depreciation charges will be substantially greater than they were in 2012.” Comment. 5-24 “Depreciation is an integral part of a statement of cash flows.” Do you agree? Explain.

219

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5-25 “The balance sheet equation helps explain the income statement and balance sheet, but it is not useful in interpreting the statement of cash flows.” Do you agree? Explain. 5-26 Demonstrate how the fundamental balance sheet equation can be recast to focus on cash. 5-27 A company operated at a profit for the year, but cash flow from operations was

negative. Why might this occur? What industry or industries might find this a common occurrence? 5-28 A company operated at a loss for the year, but cash flow from operations was positive. Why might this occur? What industry or industries might find this a common occurrence?

Critical Thinking Questions  OBJECTIVE 9

5-29 Cash Flow Patterns and Growth You are considering an investment in a company that has negative cash low from operations, negative cash low from investing, and positive cash low from inancing. All the inancing in the current year is from short-term debt. What does this pattern of cash low tell you about the client’s circumstance. How does this affect your investment decision?

 OBJECTIVE 9

5-30 Google and Cash Generation On September 30, 2011, Google was generating increasing amounts of cash from operating activities each year and was unable to fully use it to grow the business. Hence, the levels of liquid investments were increasing so that cash, cash equivalents, and marketable securities comprised 62% of the company’s assets. What would you imagine Google’s management might have been considering as a means of using the cash and liquid investment assets?

 OBJECTIVE 9

5-31 Amazon and Negative Cash Flow from Operations Between 2004 and 2010, Amazon.com, the industry leader in online sales of books and other consumer products, increased its free cash low from $477 million to $2,516 million. Prior to 2002, Amazon had never generated positive net cash low from operations. What does this tell you about the stage of growth that Amazon is in?

 OBJECTIVE 9

5-32 Failures to Generate Positive Net Cash Flow from Operations You are discussing your investment strategies with a colleague who says, “I would never invest in a company that is not generating both positive earnings and positive net cash low from operations.” How do you respond?

Exercises  OBJECTIVE 3

 OBJECTIVE 3

5-33 Simple Statement of Cash Flows from Financing Activities Gumbo, Inc., is a seafood restaurant in New Orleans. Gumbo began business in January 20X1 when investors bought common stock for $100,000 cash. Gumbo also borrowed $55,000 from Stateside Bank on January 15, on which it paid interest of $3,000 on July 15. In January the company invested $80,000 in machinery and equipment and signed a monthly rental agreement on a building with rental payments of $4,000 a month. During 20X1 Gumbo had net income of $14,000 on sales of $249,000. On December 15 the company declared and paid cash dividends of $2,000 to its common stockholders. On December 31 the company paid $10,000 to buy common shares back from the stockholders. Prepare a statement of cash flows from financing activities for the year 20X1. 5-34 Financing Activities, IFRS and U.S. GAAP During 20X0, the Southampton Shipping Company, a company reporting under IFRS, reinanced its long-term debt. It spent £165,000 to retire long-term debt due in 2 years and issued £180,000 of 15-year bonds (£ signiies pound, the UK monetary unit). It then bought and retired common shares for cash of £35,000. Interest expense for 20X0 was £23,000, of which it paid £22,000 in cash; the other £1,000 was still payable at the end of the year. Dividends declared and paid during the year were £11,000. Prepare a statement of cash flows from financing activities. Discuss the treatment of interest expense under IFRS compared with U.S. GAAP.

ASSIGNMENT MATERIAL

5-35 Investing Activities Tasman Trading Company issued common stock for $320,000 on the irst day of 20X0. The company bought ixed assets for $175,000 cash and inventory for $75,000 cash. Late in the year, it sold ixed assets for cash equal to their book value of $20,000. It sold one-half the inventory for $55,000 cash during the year. On December 15, the company used excess cash of $65,000 to purchase common stock of Fellski Company, which Tasman regarded as a long-term investment. Prepare a statement of cash flows from investing activities for Tasman Trading Company.

 OBJECTIVE 4

5-36 Noncash Investing and Financing Activities Wellstone Company had the following items in its statement of cash lows or its schedule of noncash investing and inancing activities.

 OBJECTIVES 3, 4

Note payable issued for acquisition of fixed assets Retirement of long-term debt

$144,000 565,000

Common stock issued on conversion of preferred shares

340,000

Purchases of marketable securities

225,000

Mortgage assumed on acquisition of warehouse

530,000

Increase in accounts payable

47,000

Prepare a schedule of noncash investing and financing activities, selecting appropriate items from the preceding list. 5-37 Cash Received from Customers Northgate Publishers, Inc., had sales of $900,000 during 20X1, 80% of them on credit and 20% for cash. During the year, accounts receivable increased from $60,000 to $90,000, an increase of $30,000. What amount of cash was received from customers during 20X1? 5-38 Cash Paid to Suppliers Cost of Goods Sold for Northgate Publishers, Inc., during 20X1 was $600,000. Beginning inventory was $100,000, and ending inventory was $150,000. Beginning trade accounts payable were $24,000, and ending trade accounts payable were $42,000. What amount of cash did Northgate pay to suppliers? 5-39 Cash Paid to Employees Northgate Publishers, Inc., reported Wage and Salary Expense of $220,000 on its 20X1 income statement. It reported cash paid to employees of $185,000 on its statement of cash lows. The beginning balance of Accrued Wages and Salaries Payable was $18,000. What was the ending balance in Accrued Wages and Salaries Payable? Ignore payroll taxes.

 OBJECTIVE 5  OBJECTIVE 5

 OBJECTIVE 5

5-40 Simple Cash Flows from Operating Activities Neptune Strategy, Inc., provides consulting services. In 20X1, net income was $185,000 on revenues of $460,000 and expenses of $275,000. The only noncash expense was depreciation of $35,000. The company has no inventory. Accounts receivable increased by $5,000 during 20X1, and accounts payable and salaries payable were unchanged. Prepare a statement of cash lows from operating activities. Use the direct method. Omit supporting schedules.

 OBJECTIVE 5

5-41 Net Income and Cash Flow Refer to Problem 5-40. Prepare a schedule that reconciles net income to net cash low from operating activities.

 OBJECTIVE 6

5-42 Identify Operating, Investing, and Financing Activities The following listed items were found on a recent statement of cash lows for Verizon Communications, Inc. For each item, indicate which section of the statement should contain the item—the operating, investing, or inancing section. Also, indicate whether Verizon uses the direct or indirect method for reporting cash lows from operating activities. a. Net income b. Dividends paid c. Proceeds from long-term borrowings

 OBJECTIVE 2

221

222

CHAPTER 5 • STATEMENT OF CASH FLOWS

d. e. f. g. h. i.

 OBJECT IVES 5, 6

Capital expenditures Proceeds from sale of common stock Retirements of long-term borrowings Change in inventories Depreciation and amortization expense Proceeds from dispositions [of assets]

5-43 Simple Direct- and Indirect-Method Statements Wayzata Company saw its cash plummet by $110,000 in 20X0. The company’s president wants an explanation of what caused the decrease in cash despite income of $60,000. He has asked you to prepare both direct and indirect method statements of cash lows from operations for 20X0. You have discovered the following information: • • • • • • • •

Sales, all on credit, were $560,000. Accounts receivable increased by $130,000. Cost of goods sold was $390,000. Payments to suppliers were $455,000. Accounts payable decreased by $40,000. Inventory increased by $25,000. Operating expenses were $95,000, all paid in cash except for depreciation of $30,000. Income tax expense was $15,000; taxes payable decreased by $5,000.

1. Prepare a statement of cash flows from operating activities using the direct method. 2. Prepare a statement of cash flows from operating activities using the indirect method. 3. Explain why cash decreased by $110,000 when net income was a positive $60,000.

 OBJECT IVE 7

5-44 Nature of Depreciation This continues the previous Problem, 5-43. The president looked at the indirect-method cash low statement and suggested a way to help the cash low problem. He suggested tripling the depreciation from $30,000 to $90,000 a year. That way, the cash low will improve by $60,000 annually. Explain why this reasoning is faulty.

 OBJECT IVE 7

5-45 Depreciation and Cash Flows (Alternate is 5-67.) Sawadi Thai Restaurant had sales of $880,000, all received in cash. Total operating expenses were $580,000. All except depreciation were paid in cash. Depreciation of $90,000 was included in the $580,000 of operating expenses. Ignore income taxes. 1. Compute net income and net cash provided by operating activities. 2. Assume that nondepreciation expenses are the same as in part 1 but that depreciation is tripled. Compute net income and net cash provided by operating activities.

 OBJECT IVE 8

5-46 Balance Sheet Equation of Statement of Cash Flows When you hear the name Rolls-Royce Holdings plc you probably think of luxury automobiles. However, today the company is mainly in aerospace, marine, and energy ields. The company’s condensed December 31, 2011, balance sheet follows (in millions of British pounds): Assets Cash and cash equivalents Trade and other receivables Other assets Total assets

Liabilities and Stockholders’ Equity £ 1,310 Trade and other payables 4,009 Other liabilities 11,104 Stockholders’ equity £ 16,423 Total liabilities and stockholders’ equity

£

6,236 5,668 4,519

£ 16,423

1. Prepare a balance sheet equation for Rolls-Royce Holdings in a format that supports the statement of cash flows. 2. Suppose that during the next month trade and other receivables increased by £500, other assets increased by £300, trade and other payables decreased by £150, other liabilities decreased by £50, and stockholders’ equity was unchanged. What would be the balance in cash and cash equivalents at the end of the month?

ASSIGNMENT MATERIAL

5-47 Free Cash Flow GlaxoSmithKline, the global maker of medicines, vaccines, and consumer health-care products and headquartered in the United Kingdom, reported net cash inlow from operating activities of £6,250 million in 2011. The company included the following among its items in the investing and inancing sections of its cash low statement (in millions of British pounds): Purchase of property, plant, and equipment Purchase of intangible assets Purchase of equity investments Purchase of businesses, net of cash acquired Dividends paid to shareholders

 OBJECTIVE 9

£ (923) (405) (76) (264) (3,406)

Compute GlaxoSmithKline’s free cash flow in at least two ways. Discuss the adequacy of the company’s free cash flow.

Problems 5-48 Statement of Cash Flows, Effect of Exchange Rates, Japan Kansai Electric supplies power to an area of Japan that includes Osaka and Kyoto. Its operating revenues are nearly ¥2.8 trillion (about $33 billion in U.S. dollars), and its assets are more than ¥7.3 trillion. The bottom of Kansai Electric’s 2011 cash flow statement contained the following (in millions of Japanese yen, ¥): Net cash provided by operating, investing, and financing activities Effect of exchange rate changes on cash and cash equivalents

¥ 18,228 (303)

Net increase in cash and cash equivalents

17,925

Cash and cash equivalents, beginning of year

77,525

Cash and cash equivalents, end of year

 OBJECTIVE 2

¥ 95,450

Is the effect of exchange rate changes on cash and cash equivalents a cash flow? Explain why Kansai Electric included it on the company’s cash flow statement. 5-49 Cash Flows from Financing Activities ConAgra Foods, Inc. is one of North America’s leading food companies with brands such as Banquet and Healthy Choice. Its 2011 sales exceeded $12 billion. ConAgra’s 2011 statement of cash flows included the following items, among others ($ in millions): Cash dividends paid

$ (374.5)

Repurchase of ConAgra Foods common shares

(825.0)

Additions to property, plant, and equipment

(466.2)

Depreciation and amortization

360.9

Exercise of stock options and issuance of other stock awards

59.7

Sale of property, plant, and equipment

18.9

Increase in inventories

(190.7)

Net income

818.8

Repayments of long-term debt

(294.3)

Other financing items

2.1

1. Prepare the section “Cash flows from financing activities” from ConAgra’s 2011 annual report. All items necessary for that section appear in the preceding list. The list also includes some items from other sections that should not be included among the financing activities. 2. Did ConAgra’s financing activities increase or decrease cash during 2011? By how much? What were the main causes of this increase or decrease?

 OBJECTIVE 3

223

224

CHAPTER 5 • STATEMENT OF CASH FLOWS

 OBJECT IVE 4

5-50 Cash Flows from Investing Activities Johnson & Johnson is a health-care company with headquarters in New Brunswick, New Jersey. Its revenues in the fiscal year ended January 1, 2012, were more than $65 billion. Following are items from the company’s statement of cash flows for that year. The list includes all items in the investing activities section of the statement plus some items from the operating and financing sections. Additions to property, plant, and equipment Proceeds from long-term debt Increase in accounts receivable

$ (2,893) 4,470 (915)

Proceeds from the disposal of assets

1,342

Dividends to shareholders

(6,156)

Acquisitions, net of cash acquired

(2,797)

Depreciation and amortization of property and intangibles

3,158

Purchases of investments

(29,882)

Sales of investments

30,396

Other (primarily purchases of intangibles)

(778)

Prepare the section “Cash flows from investing activities” for Johnson & Johnson for the fiscal year ending January 1, 2012.

 OBJECT IVE 4

5-51 Cash Flows from Investing Activities—IFRS Vodafone Group Plc is a large UK-based telecommunications company that reports using IFRS. Its revenues in fiscal 2011 were more than £45 billion (where £ is the British pound). The company’s statement of cash flows for fiscal 2011 contained the following items (British pounds in millions): Purchase of interests in subsidiaries and joint ventures, net of cash acquired Proceeds from issue of long-term borrowings

£ (402) 4,861

Purchase of intangible assets

(4,290)

Purchase of property, plant, and equipment

(4,350)

Increase in trade and other receivables

(387)

Purchase of investments

(318)

Disposal of property, plant, and equipment Depreciation and amortisation

51 7,876

Disposal of investments

4,467

Repayment of borrowings

(4,064)

Dividends received from associates Dividends received from investments Interest received Taxation on investing activities Profit for the financial year

1,424 85 1,659 (208) 7,870

1. Prepare the section “Cash flows from investing activities” for Vodaphone for the 2011 fiscal year. Vodaphone includes interest and dividends received and the related taxes as investing activities. All items from the investing activities section are included in the preceding list, along with some items from other sections of the statement of cash flows. 2. Prepare the section “Cash flows from investing activities” for Vodaphone for the 2011 fiscal year using U.S. GAAP.

ASSIGNMENT MATERIAL

5-52 Noncash Investing and Financing Activities The Arcadia Company operates a chain of video game arcades. Among Arcadia’s activities in 20X0 were the following:

 OBJECTIVES 3, 4

1. The firm traded four old video games to another amusement company for one new Primeval Hunt game. The old games could have been sold for a total of $3,000 cash. 2. The company paid off $50,000 of long-term debt by paying $20,000 cash and signing a $30,000 6-month note payable. 3. The firm issued debt for $60,000 cash, all of which was used to purchase new games for its Northwest Arcade. 4. The company purchased the building in which one of its arcades was located by assuming the $100,000 mortgage on the structure and paying $20,000 cash. 5. Debt holders converted $65,000 of debt to common stock. 6. The firm refinanced debt by paying cash to buy back an old issue at its call price of $21,000 and issued new debt at a lower interest rate for $21,000. Prepare a schedule of noncash investing and financing activities to accompany a statement of cash flows. 5-53 Statement of Cash Flows, Direct Method (Alternates are 5-54 and 5-55.) Charleston Aerospace Company had cash and cash equivalents of $200 million on December 31, 2011. The following items are on the company’s statement of cash flows ($ in millions) for the first 6 months of 2012: Capital expenditures for property and equipment Receipts from customers

$ (1,710) 9,455

Interest paid, net

(190)

Repurchase of common stock

(193)

Sales of marketable securities

191

Retirement of long-term debt

(160)

Payments to suppliers and employees

 OBJECTIVE 5

(7,499)

Issuance of common stock for employee stock plans

251

Dividend payments

(17)

Issuance of long-term debt

135

Other investing activity

(134)

Taxes paid

(167)

Prepare a statement of cash flows for the first 6 months of 2012 using the direct method. Include the balance of cash and cash equivalents at year-end 2011 and calculate the cash balance at June 30, 2012. Omit the schedule reconciling net income to net cash provided by operating activities and the schedule of noncash investing and financing activities. 5-54 Prepare a Statement of Cash Flows, Direct Method (Alternates are 5-53 and 5-55.) Cascade Tile is a wholesale distributor of ceramic tiles. Its cash balance on December 31, 20X0, was $226,000, and net income for 20X1 was $312,000. Its 20X1 transactions affecting income or cash follow ($ in thousands): 1. Sales of $1,500 were all on credit. Cash collections from customers were $1,390. 2. The cost of items sold was $800. Purchases of inventory on account totaled $850; inventory and accounts payable were affected accordingly. 3. Cash payments on trade accounts payable totaled $815. 4. Accrued salaries and wages: total expense, $190; cash payments, $200. 5. Depreciation was $45. 6. Interest expense, all paid in cash, was $13.

 OBJECTIVE 5

225

226

CHAPTER 5 • STATEMENT OF CASH FLOWS

7. 8. 9. 10. 11.

Other expenses, all paid in cash, totaled $100. Income taxes accrued were $40; income taxes paid in cash were $35. A warehouse was purchased for $435 cash. Long-term debt was issued for $125 cash. Cash dividends of $41 were paid.

Prepare a statement of cash flows for 20X1 using the direct method for reporting cash flows from operating activities. Omit supporting schedules.

 OBJECTIVE 5

5-55 Prepare a Statement of Cash Flows, Direct Method (Alternates are 5-53 and 5-54.) Hiramatsu Exports, Inc., is a wholesaler of Japanese goods. By the end of 20X0, the company’s cash balance had dropped to ¥9 million, despite net income of ¥254 million in 20X0. Its transactions affecting income or cash in 20X0 were as follows (¥ in millions): 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14.

Sales were ¥2,610, all on credit. Cash collections from customers were ¥2,515. The cost of items sold was ¥1,699. Inventory increased by ¥56. Cash payments on trade accounts payable were ¥1,758. Payments to employees were ¥305; accrued wages payable decreased by ¥24. Other operating expenses, all paid in cash, were ¥94. Interest expense, all paid in cash, was ¥26. Income tax expense was ¥105; cash payments for income taxes were ¥108. Depreciation was ¥151. A warehouse was acquired for ¥540 cash. Equipment was sold for ¥47; original cost was ¥206, accumulated depreciation was ¥159. The firm received ¥28 for issue of common stock. Long-term debt was retired for ¥21 cash. The company paid cash dividends of ¥98.

Prepare a statement of cash flows for 20X0 using the direct method for reporting cash flows from operating activities. Calculate the cash balance as of January 1, 20X0. Omit supporting schedules.

 OBJECTIVE 5

5-56 Prepare Statement of Cash Flows from Income Statement and Balance Sheet (Alternate is 5-58.) During 20X1, Jacinta Manufacturing Company (JMC) declared and paid cash dividends of $10,000. Late in the year, JMC bought new welding machinery for a cash cost of $125,000, financed partly by its first issue of long-term debt. Interest on the debt is payable annually. JMC sold several old machines for cash equal to their aggregate book value of $5,000. The company pays taxes in cash as incurred. The following data are in thousands:

Jacinta Manufacturing Company Income Statement for the Year Ended December 31, 20X1 Sales

$490 300

Cost of sales Gross margin Salaries

190 $82

Depreciation

40

Cash operating expenses

15

Interest Income before taxes Income taxes Net income

2

139 51 8 $ 43

ASSIGNMENT MATERIAL

Jacinta Manufacturing Company Balance Sheets December 31 20X1

Increase

20X0

(Decrease)

Assets Cash and cash equivalents

$125

$ 45

$ 80

45

60

(15)

Accounts receivable Inventories Total current assets

62 167

(5) 60

190

110

80

$417

$277

$140

$ 26

$ 21

$

Fixed assets, net Total assets

57 227

Liabilities and Stockholders’ Equity Accounts payable Interest payable

5

2



2

Long-term debt

100



100

Paid-in capital

220

220



69

36

33

$417

$277

$140

Retained earnings Total liabilities and stockholders’ equity

Prepare a statement of cash flows for 20X1. Use the direct method for reporting cash flows from operating activities. Omit supporting schedules. Assume that Jacinta paid expense items in cash unless balance sheet changes indicate otherwise. 5-57 Statement of Cash Flows, Direct Method The J.M. Smucker Company had net sales of $4,826 million from selling products such as jam (Smucker’s), peanut butter (Jif), and vegetable oils (Crisco) for the year ending April 30, 2011. The income statement showed operating expenses of $4,042 million, other expenses of $67 million, and income taxes of $238 million. The company’s statement of cash flows, prepared under the indirect method, contained the items presented in the following table where negative numbers represent reductions in cash. Of the items listed, assume that Depreciation and amortization and Other net noncash expenses (benefits) affect operating expenses and that Other changes in current assets and liabilities, net affect other expenses. (in millions) Proceeds from long-term debt

$ 400

Dividends paid

(194)

Additions to property, plant, and equipment

(180)

Purchases of marketable securities

(76)

Sales and maturities of marketable securities

57

Disposal of property, plant, and equipment Repurchase of common stock Other financing activities, net

6 (389) 13

Net income

479

Depreciation and amortization

240

Other net noncash expenses (benefits)

(7)

Changes in operating assets and liabilities Increase in trade receivables

(103)

Increase in inventories

(204)

Increase in accounts payable and accrued liabilities

85

Decrease in income taxes payable

(66)

Other changes in current assets and liabilities, net

(32)

 OBJECTIVE 5

227

228

CHAPTER 5 • STATEMENT OF CASH FLOWS

1. Assume that these are all the items in Smucker’s cash flow statement. Prepare the statement of cash flows for J.M. Smucker using the direct method for reporting cash flows from operating activities. Omit the schedule reconciling net income to net cash provided by operating activities. 2. Discuss the relation between operating cash flow and investing and financing needs.

 OBJECT IVE 5

5-58 Prepare Statement of Cash Flows from Income Statement and Balance Sheet (Alternate is 5-56.) Cape Town Manufacturing had the following income statement and balance sheet items (in millions of rands, the South African currency):

Income Statement For the Year Ended December 31, 20X1 Sales

R925

Cost of goods sold

(545)

Gross margin

380

Operating expenses

(220)

Depreciation

(60)

Interest

(15)

Income before taxes

85

Income taxes

(25)

Net income

60

Cash dividends declared and paid

(33) R 27

Total increase in retained earnings

Balance Sheets

450

350

Total current assets

717

560

157

Fixed assets, gross

890

715

175

(570)

(550)

(20)

320

165

155

R1,037

R725

R312

R 515

R300

R215

250

180

70

Accumulated depreciation Fixed assets, net Total assets

100

Liabilities and stockholders’ equity Trade accounts payable Long-term debt Stockholders’ equity Total liabilities and stockholders’ equity

272

245

27

R1,037

R725

R312

During 20X1, Cape Town purchased fixed assets for R315 million cash and sold fixed assets for their book value of R100 million. Operating expenses, interest, and taxes were paid in cash. No long-term debt was retired. Prepare a statement of cash flows for 20X1. Use the direct method for reporting cash flows from operating activities. Omit supporting schedules.

ASSIGNMENT MATERIAL

5-59 Statement of Cash Flows, Direct Method, Interest Expense, Australia CSR Limited is a leading supplier of building and construction materials headquartered in Sydney, Australia. The company’s 2011 total assets were more than A$2.2 billion, where A$ is the Australian dollar. The following items appeared in CSR’s 2011 statement of cash flows (in millions), which it reports using the direct method: Receipts from customers

 OBJECTIVE 5

A$ 3,400

Payments to suppliers and employees

(3,142)

Dividends and distributions received

7

Interest received

13

Other cash paid for operating activities

(28)

Net cash from operating activities

185

Purchase of property, plant, and equipment

(143)

Proceeds from sale of property, plant, and equipment Net repayments of borrowings

49 (795)

Net cash from disposal of discontinued operations

1,873

Dividends paid

(307)

Capital return to CSR Limited shareholders

(661)

Other investing activities

(60)

Income taxes paid

(65)

Net cash from investing activities

1,719

Proceeds from issue of shares

3

Interest and other finance cost paid

(41)

Net cash from financing activities

(1,801)

Net increase in cash

?

1. Prepare a statement of cash flows for CSR Limited using the direct method. Include the proper amount for the net increase in cash. One item, interest paid, is included in a different section of the statement than it would be on a U.S. statement of cash flows. Place it in the section that makes the cash flows in each section total to the amounts given. 2. What does the placement of interest paid tell you about the GAAP used by CSR Limited? That is, does it report under IFRS or U.S. GAAP? Where would the interest paid be shown in a statement of cash flows using the other GAAP (IFRS or U.S. GAAP)? 3. Explain why CSR places interest paid where it does. Also explain why interest paid might be placed in the alternative section you indicated in requirement 2. 5-60 Reconcile Net Income and Net Cash Provided by Operating Activities (Alternate is 5-63.) Refer to Problem 5-54 regarding Cascade Tile. Prepare a supporting schedule that reconciles net income to net cash provided by operating activities. 5-61 Cash Provided by Operations Clorox Company is a leading producer of laundry additives, including Clorox liquid bleach. In the 6 months ended December 31, 2011, net sales of $2,526 million produced net earnings of $235 million. To calculate net earnings, Clorox recorded $89 million in depreciation and amortization. Other items of revenue and expense not requiring cash decreased net earnings by $21 million. Dividends of $159 million were paid during the period. Among the changes in balance sheet accounts during the period were the following ($ in millions): Accounts receivable Inventories Accounts payable and accrued liabilities Income taxes payable

$ 35 65

Decrease Increase

136

Decrease

11

Decrease

Compute the net cash provided by operating activities using the indirect method.

 OBJECTIVE 6  OBJECTIVE 6

229

230

CHAPTER 5 • STATEMENT OF CASH FLOWS

 OBJECTIVE 6

5-62 Cash Flows from Operating Activities, Indirect Method Sumitomo Metal Industries, Ltd., is a leading diversified manufacturer of steel products. During the year ended March 31, 2011, Sumitomo had a net loss of ¥36 billion on revenues of approximately ¥1,402 billion (or more than $17 billion in U.S. dollars). The following summarized information relates to Sumitomo’s statement of cash flows: (billions of yen) Depreciation and amortization

¥127

Repayments of long-term debt Proceeds from long-term debt Other noncash revenues and expenses, net Decrease in receivables Increase in inventories Other, net Acquisition of property, plant, equipment, and other assets Increase in payables

130 74 53 37 14 17 116 18

Compute the net cash provided by operating activities using the indirect method. All the information necessary for that task is provided, together with some information related to other elements of the cash flow statement. Note that the format does not include parentheses to differentiate elements that increase cash from those that decrease cash, but the distinction should be clear from the captions (except for “Other noncash revenues and expenses, net” and “Other, net,” which are both increases in cash).

 OBJECTIVE 6

5-63 Reconcile Net Income and Net Cash Provided by Operating Activities (Alternate is 5-60.) Refer to Problem 5-55. Prepare a supporting schedule to the statement of cash flows that reconciles net income to net cash provided by operating activities.

 OBJECTIVE 6

5-64 Indirect Method: Reconciliation Schedule in Body of Statement Refer to Problem 5-56. Prepare a statement of cash flows that includes a reconciliation of net income to net cash provided by operating activities in the body of the statement.

 OBJECTIVE 6

5-65 Cash Flows, Indirect Method The Jawarski Company has the following balance sheet data ($ in millions): December 31

December 31

20X1 20X0 Change

20X1 20X0 Change

Current assets Cash

$

5 $ 21

$ (16)

Current liabilities (summarized)

$101 $ 26

$ 75

Receivables, net

53

15

38

Long-term debt

150



150

Inventories

94

50

44

Stockholders’ equity

201

160

41

152

86

66

300

100

200

–—— –——

–——

$452 $186

$266

$452 $186

$266

Total current assets Plant assets (net of accumulated depreciation) Total assets

Total liabilities and stockholders’ equity

Net income for 20X1 was $55 million. Net cash inflow from operating activities was $88 million. Cash dividends paid were $14 million. Depreciation was $40 million. Fixed assets were purchased for $240 million, $150 million of which was financed via the issuance of long-term debt outright for cash. Georg Jawarski, the president and majority stockholder of the Jawarski Company, was a superb operating executive. He was imaginative and aggressive in marketing, and ingenious and creative in production. However, he had little patience with financial matters. After examining the most recent balance sheet and income statement, he muttered, “We’ve enjoyed 10 years of steady growth; 20X1 was our most profitable ever. Despite such profitability, we’re in the worst cash position in our history. Just look at those current liabilities in relation to our available cash! This whole picture of the more you make, the poorer you get, just does not make sense. These statements must be wrong.”

ASSIGNMENT MATERIAL

1. Prepare a statement of cash flows for 20X1 using the indirect method. 2. By using the statement of cash flows and other information, write a short memorandum to Jawarski, explaining why there is such a squeeze on cash. 5-66 Prepare Statement of Cash Flows The Feinstein Company has assembled the accompanying balance sheets and statement of income and retained earnings for 20X4. Feinstein Company Balance Sheets as of December 31 (in millions) 20X4

20X3

Change

$

$ 22

$ (18)

Assets Cash

4

Accounts receivable

52

31

21

Inventory

70

50

20

Prepaid general expenses Plant assets, net

4

3

1

207

150

57

$337

$256

$ 81

$ 74

$ 60

$ 14

3

2

1

Liabilities and shareholders’ equity Accounts payable for merchandise Accrued tax payable Long-term debt

54



Capital stock

100

100

54

Retained earnings

106

94

12

$337

$256

$ 81



Feinstein Company Statement of Income and Retained Earnings for the Year Ended December 31, 20X4 (in millions) Sales

$282

Less: Cost of goods sold Inventory, December 31, 20X3

$ 50

Purchases

185

Cost of goods available for sale

235

Inventory, December 31, 20X4

70

Gross profit

165 117

Less: Other expenses General expense

51

Depreciation

40

Taxes

10

Net income Dividends declared and paid Net income of the period retained

101 16 4 12

Retained earnings, December 31, 20X3

94

Retained earnings, December 31, 20X4

$106

On December 30, 20X4, Feinstein paid $103 million in cash to acquire a new plant to expand operations. This was partly financed by an issue of long-term debt for $54 million in cash. Plant assets were sold for their book value of $6 million during 20X4. Because net income was $16 million, the highest in the company’s history, Isaac Feinstein, the chief executive officer, was distressed by the company’s extremely low cash balance. 1. Prepare a statement of cash flows for 20X4 using the direct method for reporting cash flows from operating activities.

 OBJECTIVES 5, 6

231

232

CHAPTER 5 • STATEMENT OF CASH FLOWS

2. Prepare a schedule that reconciles net income to net cash provided by operating activities. 3. What is revealed by the statement of cash flows? Does it help you reduce Mr. Feinstein’s distress? Why? Briefly explain to Mr. Feinstein why cash has decreased even though net income was $16 million.

 OBJECT IVE 7

5-67 Depreciation and Cash Flows (Alternate is 5-45.) The following condensed income statement and reconciliation schedule are from the annual report of Tran Company ($ in millions): Sales Expenses Net income

$425 350 $ 75

Reconciliation Schedule of Net Income to Net Cash Provided by Operating Activities Net income Add noncash expenses: Depreciation Deduct net increase in noncash operating working capital Net cash provided by operating activities

$ 75 25 (17) $ 83

A shareholder has suggested that the company switch from straight-line to accelerated depreciation on its annual report to shareholders, maintaining that this will increase the cash flow provided by operating activities. According to the stockholder’s calculations, using accelerated methods would increase depreciation to $48 million, an increase of $23 million; net cash flow from operating activities would then be $106 million. 1. Suppose Tran Company adopts the accelerated depreciation method proposed. Compute net income and net cash flow from operating activities. Ignore income taxes. 2. Use your answer to requirement 1 to prepare a response to the shareholder.

 OBJECT IVES 6, 8

5-68 Balance Sheet Equation (Alternate is 5-69.) Refer to Problem 5-66, Feinstein Company, requirement 1. Support the operating section of your cash flow statement by using a form of the balance sheet equation. (See Exhibit 5-8 on p. 208.) Use the equation Cash = Liabilities + Retained Earnings - Noncash Assets, and show how the direct-method and indirect-method statements arrive at the same total cash provided by operating activities.

 OBJECT IVE 8

5-69 Balance Sheet Equation (Alternate is 5-68.) Examine the data for Cascade Tiles, Inc., in Problem 5-54. Support the operating section of your cash flow statement by using a form of the balance sheet equation. (See Exhibit 5-8 on p. 208.) Use the equation Cash = Liabilities + Retained Earnings - Noncash Assets, and show how the direct-method and indirect-method statements arrive at the same total cash provided by operating activities.

 OBJECT IVES

5-70 Comprehensive Statement of Cash Flows During the past 30 years, Only Toys, Inc., has grown from a single-location specialty toy store into a chain of stores selling a wide range of children’s products. Its activities in 20X1 included the following:

3, 4, 5, 6

1. The organization issued $1,906,000 in long-term debt; $850,000 of the proceeds was used to retire debt that became due in 20X1 and was listed on the books at $850,000. 2. The company purchased 40% of the stock of Bozeman Toy Company for $3,900,000 cash. 3. The firm purchased property, plant, and equipment for $1,986,000 cash, and sold property with a book value of $600,000 for $600,000 cash. 4. The company signed a note payable for the purchase of new equipment; the obligation was listed at $516,000. 5. Executives exercised stock options for 8,000 shares of common stock, paying cash of $170,000. 6. On December 30, 20X1, the firm bought Salzburg Musical Instruments Company by issuing common stock with a market value of $305,000.

ASSIGNMENT MATERIAL

7. The company issued common stock for $3,300,000 cash. 8. The firm withdrew $800,000 cash from a money market fund that was considered a cash equivalent. 9. The company bought $249,000 of treasury stock to hold for future exercise of stock options. 10. Long-term debt of $960,000 was converted to common stock. 11. Selected results for the year follow: Net income

$ 809,000

Depreciation and amortization

615,000

Increase in inventory

72,000

Increase in accounts receivable

31,000

Increase in accounts and wages payable

7,000

Increase in taxes payable

35,000

Interest expense

144,000

Increase in accrued interest payable

15,000

Sales

9,850,000

Cash dividends received from investments

152,000

Cash paid to suppliers and employees

8,074,000

Cash dividends paid

240,000

Cash paid for taxes

390,000

Prepare a statement of cash flows for 20X1 using the direct method. Include a schedule that reconciles net income to net cash provided by operating activities. Also include a schedule of noncash investing and financing activities. 5-71 Statement of Cash Flows, Direct and Indirect Methods Nordstrom, Inc., the Seattle-based fashion retailer, had the following income statement for the year ended January 28, 2012 ($ in millions): Total revenues Costs and expenses Cost of sales and related buying and occupancy costs Selling, general, and administrative Interest expense Total costs and expenses Earnings before income taxes Income taxes Net earnings

$10,877 $6,592 3,036 130 9,758 1,119 436 $ 683

The company’s net cash provided by operating activities, prepared using the indirect method, was as follows ($ in millions): Net earnings Adjustments to reconcile net earnings to net cash provided by operating activities Depreciation, amortization, and other noncash expenses Changes in Accounts receivable Merchandise inventories Accounts payable Accrued salaries, wages, and related benefits Other liabilities Net cash provided by operating activities

$ 683

488 (98) (137) 54 6 181 $1,177

 OBJECTIVES 5, 6

233

234

CHAPTER 5 • STATEMENT OF CASH FLOWS

Prepare a statement showing the net cash provided by operating activities using the direct method. Assume that accrued salaries, wages, and related benefits and other liabilities relate to selling, general, and administrative expenses, as do all components of depreciation, amortization, and other noncash expenses.

 OBJECT IVE 9 EXHIBIT 5-16 Kellogg Company and Subsidiaries Consolidated Statement of Cash Flows, Year Ended December 31

5-72 Free Cash Flow A condensed version of the Kellogg Company statement of cash flows appears in Exhibit 5-16.

(millions)

2011

2010

2009

$1,229

$ 1,240

$1,208

Operating Activities Net earnings Items in net earnings not requiring (providing) cash Depreciation and amortization Other noncash expenses (revenues) Changes in operating assets and liabilities Net cash provided by operating activities

369

392

384

(130)

(280)

(127)

127

(344)

178

1,595

1,008

1,643

Investing Activities Additions to properties

(594)

Other Net cash used in investing activities

(474)

(377)

7

9

(587)

(465)

(370)

7

(1)

(1,354)

Financing Activities Reductions of notes payable

0

Issuances of notes payable

189

0

10

Issuances of long-term debt

895

987

1,241

Reductions of long-term debt

(945)

(1)

(482)

Net issuances of common stock

291

Common stock repurchases

(798)

(1,052)

(187)

Cash dividends

(604)

(584)

(546)

15

8

5

Other Net cash used in financing activities Increase (decrease) in cash and cash equivalents

204

(957) $

51

(439) $

104

131

(1,182) $

91

Use that statement to answer the following two questions. 1. What was Kellogg’s free cash flow for each of the 3 years shown? 2. What does the free cash flow tell us about Kellogg’s ability to generate sufficient cash flow from operations to cover ongoing investing activities and pay dividends to its shareholders?

 OBJECT IVES 3, 4

5-73 Miscellaneous Cash Flow Questions McDonald’s Corporation is a well-known provider of food services around the world. McDonald’s statements of cash flows for 2011 and 2010 are reproduced with a few slight modifications as Exhibit 5-17. Use that statement to answer the following questions:

ASSIGNMENT MATERIAL

EXHIBIT 5-17 McDonald’s Corporation Consolidated Statement of Cash Flows, Years Ended December 31 (in millions)

2011

2010

$5,503

$ 4,946

1,415

1,276

192

248

Operating Activities Net income Adjustments to reconcile to cash provided by operations Depreciation and amortization Other noncash expenses Changes in operating working capital items (161)

(50)

Inventories, prepaid expenses, and other current assets

Accounts receivable

(52)

(50)

Accounts payable

36

(40)

Income taxes

198 19

Other accrued liabilities Cash provided by operations

55 (43)

7,150

6,342

Investing Activities Capital expenditures

2,730

(2,136)

Purchases of restaurant businesses

186

(183)

Sales of restaurant businesses and property

511

378

Other

166

(115)

2,571

(2,056)

Cash used for investing activities Financing Activities Net short-term borrowings (repayments)

261

Long-term financing issuances

1,367

Long-term financing repayments

3 1,932

624

(1,147)

Treasury stock purchases

3,363

(2,699)

Common stock dividends

2,610

(2,408)

436

Other

4,533

Cash used for financing activities Effect of exchange rates on cash and cash equivalents

(97)

Cash and equivalents increase (decrease)

A

Cash and equivalents beginning of year Cash and equivalents at end of year

$

590 (3,729) 34 591

B

1,796

C

$ 2,387

1. In the financing activities section, all parentheses for 2011 have been removed. Which numbers should be put in parentheses? 2. In the investing activities section, all parentheses for 2011 have been removed. Which numbers should be put in parentheses? 3. The 2011 values for the change in cash and cash equivalents and for beginning and end-ofyear balances have been omitted and replaced with the letters A, B, and C. Provide the proper values for these three missing numbers. 4. Suppose the balance in Retained Earnings at December 31, 2010, was $33,812 million. Compute the Retained Earnings balance at December 31, 2011. Assume that all dividends declared were paid in cash in 2011. 5. Comment on the relation between cash flow from operations and cash used for investing activities. 5-74 Interpretation of the Statement of Cash Flows and Ethics Victoria, Inc., produces athletic wear. The company’s peak year was 2008. Since then, both sales and profits have fallen. The following information is from the company’s 2011 annual report ($ in thousands):

 OBJECTIVE 9

235

236

CHAPTER 5 • STATEMENT OF CASH FLOWS

Net income Accounts receivable (end of year) Inventory (end of year) Net cash provided by operations Capital expenditures Proceeds from sales of fixed assets

2011

2010

2009

$1,500 900 1,050 675 900 2,700

$4,500 1,800 2,100 1,050 1,050 1,500

$7,500 6,000 2,850 2,250 1,350 2,250

During 2012, short-term loans of $9 million became due. Victoria paid off only $2.25 million and was able to extend the terms on the other $6.75 million. Accounts payable continued at a very low level in 2012, and the company maintained a large investment in corporate equity securities, enough to generate a $3,000,000 addition to net income and $900,000 of cash dividends in 2012. Victoria neither paid dividends nor issued stock or bonds in 2012. Its 2012 statement of cash flows was as follows: Victoria, Inc. Statement of Cash Flows for the Year Ended December 31, 2012 (in thousands) Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities Add back noncash expenses: Depreciation and amortization Deduct noncash revenues: Investment revenue from equity investments, less $900 of dividends received* Net decrease in accounts receivable Net decrease in inventory Net cash provided by operating activities Cash flows from investing activities Purchase of fixed assets Insurance proceeds on building fire Sale of plant assets Purchase of corporate equity securities Net cash provided by investing activities Cash flows from financing activities Principal payments on short-term debt to banks Purchase of treasury stock Net cash used for financing activities Net increase in cash Cash, December 31, 2011 Cash, December 31, 2012

$ 1,650

600

(2,100) 150 225 $

525

(600) 3,000 3,750 (2,250) 3,900 (2,250) (900) (3,150) 1,275 1,800 $ 3,075

*

$3,000 of revenue from equity investments was included in income. $900 of this was received in the form of dividends, so $2,100 of the income was not received in cash.

1. Interpret Victoria’s statement of cash flows. 2. Describe any ethical issues relating to the strategy and financial disclosures of Victoria.

Collaborative Learning Exercise  OBJECT IVE 2

5-75 Items in the Statement of Cash Flows Form groups of four to six students each. Each member of the group should select a different company, find its statement of cash flows for a recent year, and make a list of the items included in each section of the statement: operating, investing, and financing activities. Be ready to explain the nature of each item.

ASSIGNMENT MATERIAL

1. As a group, make a comprehensive list of all items the companies listed under cash flows from operating activities. Identify those that are essentially the same but simply differ in terminology, and call them a single item. For each item, explain why and how it affects cash flows from operating activities. Note whether any of the companies selected use the direct method for reporting cash flows from operating activities. (Most companies use the indirect method, despite the fact that the FASB and IASB prefer the direct method.) If any use the direct method, separate the items listed under the direct method from those listed under the indirect method. 2. Make another comprehensive list of all items listed under cash flows from investing activities. Again, combine those that are essentially identical and differ only in terminology. For each item, explain why and how it affects cash flows from investing activities. 3. Make a third comprehensive list, this time including all items listed under cash flows from financing activities. Again, combine those that are essentially identical and differ only in terminology. For each item, explain why and how it affects cash flows from financing activities. 4. Reconvene as a class. For each of the three sections on the statement of cash flows, have groups sequentially add one item to the list of items included in the statement, simultaneously explaining why it is included in that section. Then identify the items that appear on nearly all cash flow statements and those that are relatively rare.

Analyzing and Interpreting Financial Statements 5-76 Financial Statement Research Identify an industry and select two companies within that industry.

 OBJECTIVE 9

1. Determine whether net cash flow from operations is stable through time. 2. Relate net cash flow from operations to investing and dividend payment needs. 3. Compare net cash flow from operations to net income. Explain why they differ. 5-77 Analyzing Starbucks’ Financial Statements Find Starbucks’ 2011 statement of cash flows either on Starbucks’ Web site or using the SEC’s EDGAR database.

 OBJECTIVE 9

1. Did Starbucks’ net cash provided by operating activities increase or decrease between the year ended October 3, 2010, and the year ended October 2, 2011? By how much? What item contributed most to the change? 2. Did Starbucks’ net cash used by investing activities increase or decrease between the year ended October 3, 2010, and the year ended October 2, 2011? By how much? What was the major cause of the change? 3. Explain to someone who’s not an accountant what Starbucks did with the $1,612.4 million of cash generated by operating activities during the year ended October 2, 2011. 4. Suppose a friend of yours commented, “Starbucks must have poor financial management. It  made a profit of $1,248.0 million in the year ended October 2, 2011, and it generated $1,612.4 million in cash from operations, yet it paid only $389.5 million in dividends. Its shareholders should expect more.” Respond to your friend’s comment. 5-78 Analyzing Financial Statements Using the Internet: Nike Go to www.nikebiz.com and select Investors to locate Nike’s most current financial information. 1. Take a look at Nike’s Condensed Consolidated Statement of Cash Flows. Does Nike use the direct or indirect method? How can you tell? 2. Locate Management’s Discussion and Analysis. Look under the section titled Liquidity and Capital Resources. What does management have to say about cash provided by operations? 3. Which is larger—cash provided (or used) by operations or net income for the period? Why is the cash provided by operations different from the amount of net income for the year? 4. Why does Nike add depreciation to net income in the operating activities section? 5. What were the primary uses of cash by investing activities in the most recent fiscal period? 6. What were the primary providers of cash or uses of cash by financing activities in the most recent fiscal period?

 OBJECTIVE 9

237

6

Accounting for Sales NOT MANY COMPANIES SEEK THE permission of the Central Intelligence Agency (CIA) when naming products. Yet that is precisely what System Development Laboratories did in 1977 when it created a new type of database while working on a confidential project for the U.S. government. Called the “Oracle,” this new relational database structure became the world’s most popular database management system, and for the company, now called Oracle Corporation, it was an explosive sales success story. Revenues for 2011 exceeded $35 billion for sales of software and hardware systems and related services worldwide. Recording and managing this sales revenue is important to Oracle’s success. For every sale generated, the company must either collect cash or record an account receivable from the customer. The company must then collect the accounts receivable so it has adequate cash to continue its operations. Managing accounts receivable and collecting cash are key activities for Oracle. The faster the company collects the cash, the less it will need to borrow (and the less interest it will pay). However, many customers need to obtain credit from their suppliers. Companies that push to collect cash too quickly may drive potential customers elsewhere. It took Oracle an average of 63 days to convert sales to cash in 2011. Oracle, like many other companies such as the major automobile firms, has a finance subsidiary that extends credit to its customers so that they can stretch payments over multiple years. Ford Credit and GM Financial often provide low interest car loans to help spur sales. In a recent analysis of Oracle, a security analyst presented a prominent graph displaying the revenue growth in each part of Oracle’s business. Such trends in revenue help analysts to understand what happened in the last year or the last quarter and to predict what may occur in the future. Recording revenue in the right time period is essential to measuring the rate of increase or decrease in sales. For Oracle, whose company name means “source of wisdom,” efficient and accurate measurement of revenues and tracking of accounts receivables is smart business.



LEARNING OBJECTIVES After studying this chapter, you should be able to: 1 Recognize revenue items at the proper time on the income statement. 2 Account for sales, including sales returns and allowances, sales discounts, and bank credit card sales.

3 Estimate and interpret uncollectible accounts receivable balances. 4 Assess the level of accounts receivable. 5 Manage cash and explain its importance to the company.

6 Develop and explain internal control procedures. 7 Prepare a bank reconciliation (Appendix 6).

Recognition of Sales Revenue Why is the timing of revenue recognition so important? It is critical to the measurement of net income in two ways. First, it directly increases net income by the amount of the revenue. Second, it reduces net income by triggering the recognition of certain expenses—for example, companies report the cost of the items sold in the same period in which they recognize the related revenue. Changes in revenues and net income are especially important because of the profound effects they have on stock prices. For example, the Business First box on p. 240 shows how rapid earnings growth drove extraordinary increases in Intel’s stock price in the 1990s and stagnant earnings growth arrested the increase in stock price from 2001 through the latter part of 2009. Both earnings and stock price began a slow and less predictable increase in 2010 and 2011. Sales and earnings growth are also important to managers because they often receive higher salaries or larger bonuses for increasing sales and net income. Therefore, they may prefer to recognize sales revenue as soon as possible. Owners and potential investors, however, want to be sure the economic benefits of the sale are certain before recognizing revenue. To ensure that companies record revenues in the appropriate accounting period, both IFRS and U.S. GAAP require companies to meet certain criteria before recognizing revenue. Currently, companies adhering to U.S. GAAP must meet a two-pronged test for revenue recognition as described in Chapter 2: (1) A company must have delivered the goods or services to its customer, that is, it has earned the revenue; and (2) it must have received cash or an asset virtually assured of being converted into cash, that is, the revenue must be realized or realizable. While IFRS uses different terminology in its revenue recognition criteria, the underlying principles are similar. However, particularly in the United States, these seemingly simple criteria have led to an explosion of industry- or transaction-specific guidance that has increased the complexity of revenue recognition and can result in different accounting for transactions that are economically

In just over 30 years Oracle grew from a small company to one with the huge campus pictured here. Oracle is the world’s largest enterprise software company. Its revenues exceeded $35 billion in 2011.

 OBJECTIVE 1 Recognize revenue items at the proper time on the income statement.

239

240

CHAPTER 6 • ACCOUNTING FOR SALES

BUSINESS FIRST THE INTEL DECADE OF THE 1990S … AND THE RECKONING IN THE 2000S Would you like to invest in a stock whose price increases 50-fold in just 10 years? Anyone who bought Intel’s stock in 1990 already has. Intel stock purchased for $100 mid-1990 sold for about $5,000 in mid-2000. If you had been able to read and understand Intel’s financial statements in 1990, could you have predicted this large increase in stock price? Unfortunately, you probably could not. You also could not have predicted in 2000 that by mid-2010 your $5,000 investment would fall to under $1,800 and then climb again to more than $2,500 by early 2012. If understanding financial statements was sufficient for making good investment decisions, there would be a lot of rich accountants in this world. However, looking at Intel’s financial statements from 1990 through 2000 helps explain why the company did so well over that period. The company’s financial statements from 2000 through 2011 help explain its struggles over that decade, with a slight recovery in 2010 and 2011. Intel’s revenues increased from less than $4 billion in 1990 to nearly $34 billion in 2000, a rate of growth of more than 24% per year. Meanwhile, over the same period earnings per share grew from $.10 to $1.51, more than 31% per year. If investors in 2000 expected this growth to continue, it is no wonder they were willing to pay top dollar for shares of Intel.

Do Intel’s financial statements since 2000 explain the cause of the decline in its stock price and its recent recovery? Partly. They certainly show that the anticipated growth did not occur. Revenues in 2009 were $35 billion, only $1 billion higher than in 2000. But revenues increased significantly to $43.6 billion and almost $54 billion in 2010 and 2011, respectively. Between 2000 and 2009, net income fell from $11 billion to $4 billion, and EPS fell from $1.51 to $.79, before recovering to nearly $13 billion and $2.46 in 2011. If investors had predicted these financial results, they would not have elected to hold Intel shares between 2000 and 2009. But remember, accountants simply report history—they do not predict future results. Intel is still a much larger and stronger company than it was in 1990, and shareholders who bought shares in 1990 still have more than $2,500 for every $100 invested. However, those who invested in 2000 have seen half of their money melt away. What will the future hold? It depends in part on what revenues and income Intel will generate in the future. Its financial statements will gradually reveal whether purchasing Intel stock today will turn out to be a good investment. Sources: Intel Annual Reports for 2000 and 2011; Yahoo Finance Historical Prices for Intel (http://finance.yahoo.com/q/hp?s=INTC&a=06&b=9&c=1986&d=02&e=28&f=2012&g=m &z=66&y=0).

similar. Therefore, the FASB and IASB entered into joint discussions in an attempt to improve accounting for revenues. This effort is about to conclude, and by the time you read this text the new standard may be in effect. The new standard is expected to have a five-step process for revenue recognition: Step 1: Identify the contract with a customer. Step 2: Identify the separate performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the separate performance obligations in the contract. Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation. In plain English, this means that the company and customer must approve an agreement that specifies the sales price and the list of all the products and services that transfer to the customer as a result of the sale. The company then assigns a portion of the sales price to each product or service and records revenue when the customer receives each product or service. There are two major effects of this new revenue recognition process: (1) if the entire product and/or service is not provided to the customer at the point of sale, revenue is spread over the time periods in which the products and services are delivered, and (2) there is no realization criterion, that is, collectability of the sales price does not directly affect the recording of revenues. Most companies recognize revenue at the point of sale and will continue to do so under the proposed guidance. Suppose you buy a compact disc at a local music store. The sale meets both

RECOGNITION OF SALES REVENUE

241

the current and new revenue recognition tests at the time of purchase. It meets the new standard simply because the customer receives the product at the time of the sale. Under the old standard, the store earns the revenue because it delivers the merchandise at the point of sale, and the store realizes the revenue because it receives cash, a check, or a credit card slip, all of which it can readily convert to cash. When the customer receives the entire product or service at the point of sale, the only thing that causes a difference between the old and new standards is the collectability of the sales price. Suppose a real estate company sells an acre of land in the desert to a customer for $10,000 and records an account receivable of $10,000. If there is a significant chance that the customer will not eventually pay the $10,000, current U.S. GAAP does not allow the recording of revenue. In contrast, the new standard would require recording the revenue but also require recognition that the account receivable may be uncollectible (the process for which we discuss later in the chapter). When delivery of a product or service is spread over time, both the old and new standards require delaying revenue recognition at least until the company delivers the product or service to the customer. Consider the sale of magazine subscriptions where the subscriber makes payment upfront. Under current U.S. GAAP, the realization test for revenue recognition is met at the time the publisher receives payment. However, the publisher does not record revenue until it delivers the magazines and thereby earns the revenue. Under the new standards, revenue recognition would be determined by the delivery of the product, independent of the timing of cash collection. So both the old and new standards lead to recording revenue at the same time—at delivery of the product.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Consider two types of sales by Starbucks, over-the-counter sales and sales of “stored value” cards, such as gift cards. When would Starbucks recognize the revenue from each?

Answer

for the merchandise. In contrast, when it sells a stored value card, Starbucks initially records a liability, “deferred revenue.” It then recognizes revenue when customers use their cards at retail stores. Only then has Starbucks earned the revenue by delivering the product to the customer.

Starbucks recognizes revenues from over-the-counter sales at the point of sale—as it collects cash or records a credit card payment

A more complex example of services spread over time is long-term contracts. Suppose Oracle signs a $40 million contract with the U.S. government for designing and implementing an Enterprise Resource Planning system for a branch of Homeland Security. Oracle signs the contract and immediately begins work on January 2, 20X0. The expected completion date is December 31, 20X1. The government will pay Oracle upon completion of the project. Oracle expects to complete one-half of the project each year. When should Oracle record the $40 million of revenue on its income statement? Because Oracle provides one-half of the services each year, it may seem logical that it should record half of the revenue each year—$20 million annually, even though delivery of the completed project will not occur until the end of 20X1. Under certain specified conditions, current U.S. GAAP does allow recognition of revenue during production. If Oracle’s contract meets these conditions, Oracle will apply the percentage of completion method. This method recognizes revenue on long-term contracts as production occurs and, following the matching principle, also recognizes the associated expenses. Under this method, when Oracle recognizes one-half of the revenue in 20X0, it also recognizes the expenses incurred in fulfilling that half of the contract. Under current U.S. GAAP, before applying the percentage of completion method, Oracle must determine the likelihood of receiving payment. If payment is questionable, the percentage of completion method is not appropriate. Generally, companies can count on the government and major corporations to make payments on their contracts. Because payment is virtually certain, the company realizes revenues as it earns them. In addition to the expectation of payment, the percentage of completion method is appropriate only if progress measures are dependable, contract obligations are explicit, and both the seller and buyer are expected

percentage of completion method Method of recognizing revenue on long-term contracts as production occurs, rather than waiting until the final product is delivered. The company must also recognize the associated expenses.

242

CHAPTER 6 • ACCOUNTING FOR SALES

completed contract method Method of recognizing revenue on long-term contracts that delays recognition of both revenue and related expenses until completion of the contract.

to meet their obligations. If the project does not meet these criteria, especially if there is great uncertainty about whether the customer will pay at the end of the contract, companies reporting under current U.S. GAAP would delay recognition of both revenue and related expenses until completion of the contract, a method known as the completed contract method. In contrast, under current IFRS, companies use the percentage of completion method whenever the outcome of a contract can be estimated reliably. The proposed new U.S. standard eliminates many of the hurdles to the application of the percentage of completion method. Not only does it converge the rules for percentage of completion as employed under U.S. GAAP and IFRS, but it also simplifies the accounting for long-term contracts relative to existing practice.

Measurement of Sales Revenue  OBJECT IVE 2 Account for sales, including sales returns and allowances, sales discounts, and bank credit card sales.

After deciding when to recognize revenue, accountants must determine how to measure it. To measure revenue, accountants approximate the fair value of the asset inflow from the customer. That is, they measure revenue in terms of the cash-equivalent value of the asset received. A cash sale is simplest—it increases Sales Revenue, an income statement account, and increases Cash, a balance sheet account, by the amount of the cash received. Consider a $100 sale: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . .

100

Sales revenue. . . . . . . . . . . . . . . . . . .

100

Accountants record a credit sale on open account much like a cash sale, except that it increases the balance sheet account Accounts Receivable instead of Cash: Accounts receivable . . . . . . . . . . . . . . . . Sales revenue . . . . . . . . . . . . . . . . . .

gross sales The total amount of sales before deducting returns, allowances, and discounts.

net sales The total amount of sales after deducting returns, allowances, and discounts.

sales returns (purchase returns) Merchandise returned by the customer.

sales allowance (purchase allowance) Reduction of the original selling price.

100 100

Measuring revenue is more complex when the cash-equivalent value of the asset received is not obvious. When might this happen? One case is when a company receives goods or services instead of cash for a sale. In such a situation, the company must estimate the cash-equivalent value of the goods or services received. Even when a sale is for cash, the cash received may be less than the listed price of the item sold. For example, merchants may give discounts for prompt payment or for high-volume purchases. Or sometimes the customer is unable or unwilling to pay the full amount owed. Some companies distinguish between gross sales and net sales when reporting revenues. Gross sales is the total amount of sales before deducting returns, allowances, and discounts. Net sales is the result after deducting such items. When a company makes such a distinction, it is the net sales, the amount actually received, that constitutes revenue to the company. We will next identify and examine returns, allowances, and discounts.

Merchandise Returns and Allowances Suppose a store recognizes revenue for a given sale at the point of that sale, but later the customer returns the merchandise. The purchaser may be unhappy with the product’s color, size, style, or quality, or he or she simply may have a change of heart. The store calls these sales returns; the customer calls them purchase returns. Such merchandise returns are minor for manufacturers and wholesalers, but they are major for retail department stores. For instance, returns of 12% of gross sales are not abnormal for stores such as Nordstrom or Macy’s. Sometimes, instead of returning merchandise, the customer demands a reduction of the original selling price. For example, a customer may complain about scratches on a household appliance or about buying a pair of shoes for $40 on Wednesday and seeing the same shoes on sale for $29 on Thursday. Sellers often settle such complaints by granting a sales allowance, which we treat as a reduction of the original selling price (the purchaser calls this a purchase allowance). Companies deduct both sales returns and sales allowances from gross sales to determine net sales. Instead of reducing the revenue (or sales) account directly, managers of retail stores typically

MEASUREMENT OF SALES REVENUE

243

use a contra revenue account, Sales Returns and Allowances, which combines both returns and allowances in a single account. Managers use a contra account to enable them to monitor changes in the level of returns and allowances, which may provide insights that are helpful in forecasting demand and managing inventory. For instance, a change in the percentage of returns in fashion merchandise may signal changes in customer tastes. Similarly, sellers of fashion or fad merchandise may find tracking of sales returns to be especially useful in assessing the quality of products and services from various suppliers. Also, if a company uses sales figures to determine commissions or bonuses, managers must know which sales personnel have especially high rates of sales returns or allowances. Because returns happen after the sales, accountants separately record returns and allowances to avoid going back and changing the original entries for the sale—a messy and unreliable process. How does a retailer adjust gross sales for sales returns and allowances? Suppose your local outlet of Talbots has $900,000 gross sales on credit and $80,000 sales returns and allowances. The analysis of transactions would show the following: A

=

L

+

SE

Credit sales on open account

+900,000 Increase Accounts Receivable

=

+900,000 Increase Sales

Returns and allowances

–80,000 Decrease Accounts Receivable

=

–80,000 Increase Sales Returns and Allowances

The journal entries (without explanations) are as follows: Accounts receivable. . . . . . . . . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . . Sales returns and allowances . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . .

900,000 900,000 80,000 80,000

The income statement would begin as follows: Gross sales Deduct: Sales returns and allowances Net sales or Sales, net of $80,000 returns and allowances

$900,000 80,000 $820,000 $820,000

Managers react differently to this information than they would to knowing only that net sales were $820,000. They easily see that about 9% of the company’s sales are either being returned or lost through price reductions. Then they can ask the following questions: How has this pattern changed through time? What can we do to reduce the extra service costs we incur to handle these special transactions? Should we modify our inventory selections or our inventory levels?

Trade and Cash Discounts In addition to returns and allowances, trade and cash discounts also reduce reported sales amounts. Trade discounts are reductions to the gross selling price for a particular class of customers. An example is a discount for large-volume purchases. Suppose Tartan Wholesale Co. offers no discount on the first $10,000 of merchandise purchased per order, but a 2% discount on the next $10,000 of purchases and a discount of 3% on all sales in excess of $20,000. The gross sales revenue recognized from a sale with a trade discount is the price received after deducting the discount. Thus, a trade discount is simply a reduction in the gross sales price. Tartan Wholesale

trade discounts Reductions to the gross selling price for a particular class of customers.

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would record sale of merchandise listed at $25,000 less a trade discount as follows, where the sales amount is [$10,000 + (98% × $10,000) + (97% × $5,000)] = $24,650:

Sale with trade discount

cash discounts Reductions in the amount owed by customers due to prompt payment.

A

=

+24,650 Increase Accounts Receivable or Cash

=

L

+

SE +24,650 Increase Sales

Companies set trade discount terms to be competitive in industries where such discounts are common or to encourage certain customer behavior. For example, manufacturers with seasonal products (gardening supplies, snow shovels, fans, Christmas ornaments, and so on) might offer price discounts on early orders and deliveries to smooth out production throughout the year and to minimize the manufacturer’s cost of storing the inventory. In deciding to accept early delivery, the buyer must weigh the storage costs it will incur against the reduced price the discount provides. Another type of discount, cash discounts, rewards customers for prompt payment. Sellers quote the terms of the credit sale in various ways on the invoice: Credit Terms n/30 1/5, n/30 15 E.O.M.

Meaning The full billed price (gross price) is due on the thirtieth day after the invoice date. A 1% discount can be taken for payment within 5 days of the invoice date; otherwise, the full billed price is due in 30 days. The full price is due within 15 days after the end of the month of sale; an invoice dated December 20 is due January 15.

For example, suppose a manufacturer sells $30,000 of computer equipment to Oracle on terms 2/10, n/60. Therefore, Oracle may remit $30,000 less a cash discount of (.02 × $30,000), or ($30,000 – $600) = $29,400, if it makes payment within 10 days after the invoice date. Otherwise, it must pay the full $30,000 within 60 days. We illustrate two approaches to accounting for this transaction, the gross method and the net method. If the manufacturer uses the gross method of accounting for cash discounts it would record the sale at the gross sales price of $30,000 as shown in entry 1 below. It would record entry 2 if Oracle pays within 10 days and entry 3 if Oracle pays the full amount in 60 days:

1. Sell at terms of 2/10, n/60

Followed by either 2 or 3 2. Either collect $29,400 ($30,000 less 2%)

A

=

L

+

SE

+30,000 Increase Accounts Receivable

=

+30,000 Increase Sales

+29,400 Increase Cash

=

–600 Increase Cash Discounts on Sales

=

(No Effect)

–30,000 Decrease Accounts Receivable or 3. Collect $30,000

+30,000 Increase Cash –30,000 Decrease Accounts Receivable

MEASUREMENT OF SALES REVENUE

The journal entries follow: 1. Accounts receivable . . . . . . . . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . . 2. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash discounts on sales . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . or 3. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . .

30,000 30,000 29,400 600 30,000 30,000 30,000

If the manufacturer uses the net method of accounting for the cash discounts, it would initially record the sale at the net price, as shown in entry 1 that follows. It would record entry 2 if Oracle pays within 10 days and entry 3 if Oracle pays the full amount in 60 days:

1. Sell at terms of 2/10, n/60

Followed by either 2 or 3 2. Either collect $29,400 ($30,000 less 2%)

A

=

L

+

SE

+29,400 Increase Accounts Receivable

=

+29,400 Increase Sales

+29,400

=

(No Effect)

=

+600 Increase Interest Revenue

Increase Cash –29,400 Decrease Accounts Receivable

or 3. Collect $30,000

+30,000 Increase Cash –29,400 Decrease Accounts Receivable

The journal entries for the net method follow: 1. Accounts receivable. . . . . . . . . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . . 2. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . or 3. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . Interest Revenue . . . . . . . . . . . . . . . .

29,400 29,400 29,400 29,400 30,000 29,400 600

The net method assumes that the delayed receipt of cash is essentially a loan to the customer. Cash discounts encourage prompt payment and thus reduce the seller’s need for cash. Early collection also reduces the risk of bad debts. Moreover, favorable credit terms with attractive cash discounts are a way to compete with other sellers. Should purchasers take cash discounts? The answer is usually yes, but the decision depends on interest rates. Suppose Oracle decides to pay $30,000 in 60 days, not $29,400 in 10 days. It has the use of $29,400 for an extra 50 days (60 days – 10 days) for an “interest”

245

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payment of $600. If Oracle could borrow the $29,400 from the bank at a 10% annual interest rate, the interest cost for 50 days on $29,400 is [($29,400 × 10%) × (50 ÷ 365)] = $403. It is ($600 – $403) = $197 cheaper to borrow the money from the bank. If the company does not have the cash to pay now, it should borrow the money in order to take the cash discount. Only if Oracle cannot borrow the $29,400 for less than $600 of interest should it pass up the cash discount and pay $30,000 on the sixtieth day. You could also calculate the annual interest rate implicit in the cash discount. The rate is ($600 ÷ $29,400) = 2.04% for the 50 days. During a year, there are (365 days ÷ 50 days) = 7.3 periods of 50 days. Thus, the annual rate is (2.04% per period × 7.3 periods per year) = 14.9%. Most well-managed companies, such as Oracle, can borrow for less than 14.9% interest per year, so they design their accounting systems to always take advantage of cash discounts. Usage of cash discounts varies through time and from one industry to another. You may be familiar with some gas stations that offer a lower price for cash payment, whereas other stations do not.

Recording Charge Card Transactions In a sense, companies offer cash discounts when they accept charge cards such as VISA, MasterCard, and American Express. Why? These credit card companies charge retailers a fee, and the retailers receive an amount less than the listed sales price. Why do retailers accept these cards? There are three major reasons: (1) to attract credit customers who would otherwise shop elsewhere, (2) to get cash immediately instead of waiting for credit customers to pay their accounts, and (3) to avoid the cost of tracking, billing, and collecting customers’ accounts. Most large retailers deposit credit card charges in their bank accounts immediately via electronic transmissions, and those who still use paper charge slips generally deposit them daily (just like cash). The services of a credit card company cost money (in the form of service charges on every credit sale), and companies deduct this cost from gross sales in calculating net sales revenue. Card companies’ service charges are typically from 1% to 4% of gross sales, with the large-volume retailers bearing the lowest cost as a percentage of sales. The arrangement for one large-volume retailer was 4.3 cents per transaction plus 1.08% of the gross sales using charge cards. Suppose VISA charges a company a straight 3% of sales for its credit card services. Credit sales of $10,000 will result in cash of only [$10,000 – (.03 × $10,000)] = $9,700. Managers usually report the $300 amount separately for control purposes:

A

=

L

+

SE +10,000 Increase Sales

Sales using VISA

+9,700 Increase Cash

= –300 Increase Cash Discounts for Bank Cards

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash discounts for bank cards . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . .

9,700 300 10,000

By accounting for these cash discounts separately, managers can continuously evaluate whether the costs they incur are justified.

MEASUREMENT OF SALES REVENUE

Accounting for Net Sales Revenue Because we record cash discounts (when accounted for under the gross method) and sales returns and allowances as deductions from Gross Sales, a detailed income statement might contain multiple elements as follows (numbers assumed): Gross sales Deduct: Sales returns and allowances Cash discounts on sales Net sales

$1,000 270 20

290 $ 710

Reports to shareholders typically omit details and show only net revenues. For example, Starbucks reports “total net revenues” of $11,700.4 million on its 2011 income statement. Some companies separate revenue into categories. For example, Oracle shows software revenues separately from service revenues, and Starbucks shows revenue from company-owned retail stores separately from revenue from licensing and foodservice activities.

Summary Problem for Your Review PROBLEM Carlos Lopez, marketing manager for Fireplace Distributors, sold 12 wood stoves to Woodside Condominiums, Inc. The sales contract was signed on April 27, 20X1. The list price of each wood stove was $1,200, but Lopez allowed a 5% quantity discount. He also offered a cash discount of 2% of the amount owed if Woodside paid by June 10. Fireplace Distributors delivered the wood stoves on May 10 and received the proper payment on June 9. The company uses the gross method of accounting for cash discounts. 1. How much revenue should Fireplace Distributors recognize in April, in May, and in June? Explain. 2. Suppose Fireplace Distributors has a separate account titled “Cash Discounts on Sales.” What journal entry would it make on June 9 when it receives the cash payment? 3. Suppose Fireplace Distributors has another account titled “Sales Returns and Allowances.” Suppose further that one of the wood stoves had a scratch and Fireplace Distributors allowed Woodside to deduct $100 from the total amount due. What journal entry would Fireplace Distributors make on June 9 when it receives the cash payment?

SOLUTION 1. Under current U.S. GAAP Fireplace Distributors would recognize revenue of $13,680 [(12 × $1,200) less a 5% quantity discount of $720] in May and none in April or June. The key to recognizing revenue is whether the revenue is earned and the asset received from the buyer is realized. Fireplace Distributors does not earn the revenue until it delivers the merchandise. Therefore, it cannot recognize revenue in April. Provided that Woodside Condominiums has a good credit rating, the receipt of cash is reasonably ensured before Fireplace Distributors actually receives the cash. Therefore, recognition of revenue need not be delayed until June. On May 10, both revenue recognition tests are met, and Fireplace Distributors would record the revenue on May’s income statement. However, if Woodside had a poor credit rating, Fireplace Distributors would not recognize and record the revenue until it received the cash in June. Under the proposed new revenue recognition rules, Fireplace Distributors would recognize all of the revenue in May as it has fulfilled its obligation by delivering the product to Woodside.

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2. The original revenue recorded was $13,680. The 2% cash discount is (2% × $13,680) = $273.60. Therefore, the cash received is ($13,680 – $273.60) = $13,406.40: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash discounts on sales . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . .

13,406.40 273.60 13,680.00

3. The only difference from requirement 2 is a $100 smaller cash receipt and a $100 debit to Sales Returns and Allowances: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash discounts on sales . . . . . . . . . . . . . .

13,306.40 273.60

Sales returns and allowances . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . .

100.00 13,680.00

Credit Sales and Accounts Receivable Cash sales are important for some companies, but most sales in today’s world are on credit. Credit sales create challenges for measuring revenue and managing the company’s assets because the company agrees to accept payment in the future for goods or services delivered today. Companies must manage these expected future payments, accounts receivable, to ensure their collection in a timely manner.

 OBJECTIVE 3 Estimate and interpret uncollectible accounts receivable balances.

uncollectible accounts (bad debts) Receivables determined to be uncollectible because customers are unable or unwilling to pay their debts.

bad debt expense The loss that arises from uncollectible accounts.

Uncollectible Accounts Granting credit entails both costs and benefits. The main benefit is the boost in sales and profit that a company generates when it extends credit. Many potential customers would not buy if credit were unavailable, or they would buy from a competitor that offered credit. Among the costs of providing credit is the cost of administering and collecting the credit amount. Before a company grants credit, it reviews the customer’s credit and payment history to decide whether to accept the customer. It must then track what a customer owes, send periodic bills, deposit payments, record the payment in the customer’s account, and so forth. These steps require clerical time and effort. Another cost is the delay in receiving payment. The seller must finance its activities in other ways while awaiting payment. Perhaps the most significant cost is uncollectible accounts or bad debts—receivables that some credit customers are either unable or unwilling to pay. Accountants often call the loss that arises from uncollectible accounts bad debt expense. The extent of nonpayment of debts varies. It often depends on the credit risks that managers are willing to accept. For instance, many smaller local establishments will accept a higher level of risk than will larger national stores such as Nordstrom. Why? Possibly because the local stores know their customers personally. The extent of nonpayments can also depend on the industry. For example, the problem of uncollectible accounts is especially difficult in the healthcare field. The Bayfront Medical Center of St. Petersburg, Florida, once reported bad debts equal to 21% of gross revenue.

Deciding When and How to Grant Credit Competition and industry practice affect whether and how companies offer credit. They offer credit only when the additional earnings on credit sales exceed the costs of offering credit. Suppose 5% of credit sales are bad debts, administrative costs of a credit department are $5,000 per year, and $20,000 of credit sales (with earnings of $8,000 before credit costs) are achieved. Assume that the company would not receive any of the credit sales without granting credit. Offering credit is worthwhile because the additional earnings of $8,000 exceeds the credit costs of [(5% × $20,000) + $5,000] = $6,000.

MEASUREMENT OF UNCOLLECTIBLE ACCOUNTS

249

Measurement of Uncollectible Accounts Uncollectible accounts require special accounting procedures and thus deserve special attention. Consider an example. Suppose Compuport began business on January 2, 20X1 and had credit sales of $100,000 (200 customers averaging $500 each) during 20X1. Collections during 20X1 were $60,000. The December 31, 20X1, gross accounts receivable balance of $40,000 includes the accounts of 80 different customers who have not yet paid for their 20X1 purchases. Some of those still-uncollected sales may never be received from the customers. The outstanding balances are as follows: Customer

Amount Owed

1. Jones 2. Slade

$1,400 125

> > >

> > >

> > >

> > >

42. Monterro

500

79. Weinberg 80. Porras Total receivables

700 11 $40,000

How should Compuport account for these receivables? As Compuport’s accountants, should we assume they will all be collected and report $40,000 of accounts receivable on the balance sheet? Or should we report only the amount Compuport expects to receive? If we assume some receivables will not be collected, how do we decide which are collectible and which are not? Of course, we would never have initially made a credit sale to someone we really believed would not pay us, and at the end of the year we are unlikely to know exactly which customers may not pay. There are two basic ways to record uncollectibles, the specific write-off method and the allowance method. Under the specific write-off method, the company waits to see which specific customers do not pay and only then reduces the amount receivable. Under the allowance method, at the end of the accounting period the company estimates the portion of outstanding receivables that will not be collected and reports a net accounts receivable, the gross amount less the expected uncollectibles.

Specific Write-Off Method A company that rarely experiences a bad debt might use the specific write-off method (or direct write-off method), which assumes that all sales are fully collectible until proven otherwise. If uncollectibles are small and infrequent, this practice will not misstate the economic situation in a material way. If Compuport adopts this method, it will reduce the Account Receivable when it identifies a specific customer account as uncollectible. Because Compuport deems no specific customer’s account to be uncollectible at the end of 20X1, its December 31, 20X1, balance sheet would simply show Accounts Receivable of $40,000. Now assume that during 20X2 Compuport identifies Jones and Monterro as customers who are not expected to pay. When the probability of collection from specific customers becomes small, Compuport recognizes the amounts in the particular customer’s accounts as bad debt expense: Specific Write-Off Method 20X1 Sales

20X2 Write-off

A

=

+100,000 Increase Accounts Receivable –1,900 Decrease Accounts Receivable

=

L

=

+

SE +100,000 Increase Sales –1,900 Increase Bad Debt Expense

The journal entry for the $1,900 write-off is as follows: Bad Debt Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts Receivable . . . . . . . . . . . . . . . . . . . . . .

1,900 1,900

specific write-off method (direct write-off method) A method of accounting for bad debt losses that assumes all sales are fully collectible until proven otherwise.

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CHAPTER 6 • ACCOUNTING FOR SALES

The problem with the specific write-off method is that it fails to apply the matching principle of accrual accounting. The $1,900 bad debt expense recorded using the specific write-off method in 20X2 is related to (or caused by) the $100,000 of 20X1 sales. Matching requires recognition of the bad debt expense at the same time as the related revenue, that is, in 20X1, not 20X2. As a result of not matching expenses to revenues, the specific write-off method produces two errors in reported earnings. First, Compuport overstates its 20X1 income by $1,900 because the company reports no bad debt expense that year. Second, it understates its 20X2 income by $1,900. Why? Because Compuport charges 20X1’s bad debt expense of $1,900 in 20X2. Equally important, the accounts receivable balance in 20X1 overstates the asset by $1,900. Compare the specific write-off method with a correct matching of revenue and expense: Specific Write-Off Method: Matching Violated 20X1 20X2 Sales revenue Bad debt expense 20X1 ending accounts receivable

bad debt recoveries Accounts receivable that were previously written off as uncollectible but then collected at a later date.

$100,000 0

Matching Applied Correctly 20X1 20X2

$0 1,900

40,000

$100,000 1,900

$0 0

38,100

Another error in matching can arise if a customer pays an account that a company has previously written off as uncollectible. When such bad debt recoveries occur, we must capture the customer’s true payment history. We accomplish this in two steps. First, we reverse the write-off, and then we handle the collection as a normal receipt on account. Suppose that in 20X3 Monterro unexpectedly pays the $500 that was written off in 20X2. The write-off must be reversed and the payment recorded: Accounts receivable. . . . . . . . . . . . . . . . . . 500 Bad debt expense. . . . . . . . . . . . . . . . To reverse February 20X2 write-off of account of Monterro Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 Accounts receivable . . . . . . . . . . . . . . To record the collection on account

500

500

The reduction in 20X3’s bad debt expense offsets the overstatement of 20X2’s bad debt expense, so 20X2’s income was understated and 20X3’s income will be overstated. The principal arguments in favor of the specific write-off method are based on cost-benefit and materiality. The method is simple, extremely inexpensive to use, and does not require estimation. Moreover, no great error in measurement of income or accounts receivable occurs if the amounts of bad debts are small and similar from one year to the next. allowance method

Allowance Method

A method of accounting for bad debt losses that uses (1) estimates of the amount of sales or receivables that will ultimately be uncollectible, and (2) a contra account that contains the estimated uncollectible amount to be deducted from the total accounts receivable.

Few companies use the specific write-off method because it violates the matching principle and most companies’ bad debts are neither small nor similar from year to year. Instead, most companies estimate the amount of uncollectible accounts to be matched to each year’s revenue. This method, known as the allowance method, has two basic elements: (1) an estimate of the amount of sales or receivables that will ultimately be uncollectible, and (2) a contra account that contains the estimated uncollectible amount to be deducted from the total accounts receivable. We usually call the contra account allowance for uncollectible accounts (or allowance for doubtful accounts, or allowance for bad debts). It contains the amount of receivables the company estimates to be uncollectible from as-yet unidentified customers. In other words, using this contra account allows accountants to recognize bad debts in general during the proper period, before they identify uncollectible accounts from specific individuals in the following periods. Returning to our example, suppose that Compuport knows from experience that it will not collect about 2% of sales. Therefore, the company estimates that it will not collect (2% × $100,000) = $2,000 of the 20X1 sales. However, on December 31, 20X1, it does not know which customers will fail to

allowance for uncollectible accounts (allowance for doubtful accounts, allowance for bad debts) A contra asset account that measures the amount of receivables estimated to be uncollectible.

MEASUREMENT OF UNCOLLECTIBLE ACCOUNTS

pay their accounts. Compuport can still acknowledge the $2,000 of expected bad debts in 20X1, before it identifies the specific accounts of Jones and Monterro in 20X2. The effects of the allowance method on the balance sheet equation in the Compuport example follow:

Allowance method 20X1 Sales

20X1 Allowance

20X2 Write-off

A

=

L

+

SE

+100,000 Increase Accounts Receivable –2,000 Increase Allowance for Uncollectible Accounts +1,900 Decrease Allowance for Uncollectible Accounts

=

+100,000 Increase Sales

=

–2,000 Increase Bad Debt Expense

=

(No Effect)

–1,900 Decrease Accounts Receivable

The associated journal entries are as follows: 20X1 Sales 20X1 Allowances 20X2 Write-offs

Accounts receivable. . . . . . . . . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . . Bad debt expense . . . . . . . . . . . . . . . . . . . Allowance for uncollectible accounts . . Allowance for uncollectible accounts. . . . . . Accounts receivable, Jones . . . . . . . . . Accounts receivable, Monterro. . . . . . .

100,000 100,000 2,000 2,000 1,900 1,400 500

The first journal entry represents many (200 in this example) individual sales to specific customers in 20X1 and the related increases in accounts receivable. The second entry records the estimate of bad debt expenses for 20X1, which results in an increase to the Allowance for Uncollectible Accounts. In 20X2, after exhausting all practical means of collection, Compuport decides the Jones and Monterro accounts are uncollectible, and the third entry writes off these accounts. Recording the $1,900 write-off for Jones and Monterro in 20X2 reduces their individual subsidiary accounts, reduces the general ledger Accounts Receivable account, and reduces the Allowance for Uncollectible Accounts balance to $100. The separate entries to the Jones and Monterro subsidiary ledger accounts emphasize that companies keep separate accounts receivable records for each individual customer, showing all sales and payments in the customer’s subsidiary ledger account. The total of all a particular customer’s net sales less payments and any amounts written off is the amount receivable from that customer. At any point in time, the sum of the balances of all customer accounts in the subsidiary ledger must equal the accounts receivable balance in the general ledger. We illustrate this process in Exhibit 6-1, where panel A shows the accounts at the end of 20X1 (before the write-off) and panel B shows the accounts after the write-off. The allowance method is superior in measuring annual accrual accounting income and in measuring the year-end accounts receivable asset accurately. Under this method Compuport deducts from 20X1 sales the $2,000 of those sales that it believes it will never collect. This matches the bad debt expense to the sales that generated the bad debts. In addition, the balance sheet shows a more conservative receivable balance of $38,000 at December 31, 20X1.

251

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EXHIBIT 6-1 Compuport General Ledger, December 31, 20X1 Panel A: Pre–Write-Off Allowance for Uncollectible Accounts†

Accounts Receivable Credit sales during 20X1 Bal. 12/31/X1

100,000

Collections

60,000

2,000

40,000 Bad Debt Expense 2,000 †

Accounts Receivable Subsidiary Ledger Jones

Slade

1,400

no subsidiary ledger for the allowance account

Monterro

125

500

Weinberg

Porras

700

11

and so on*

*

Total of these individual customer accounts must equal $40,000.

Panel B: Post–Write-Off Allowance for Uncollectible Accounts†

Accounts Receivable Bal. 1/1/X2

40,000

Write-off

1,900

Write-off

1,900

Bal. 1/1/X2

38,100

100 †

Accounts Receivable Subsidiary Ledger Jones 1,400

Slade 1,400

2,000

no subsidiary ledger for the allowance account

Monterro

125

500

Weinberg

Porras

700

11

500

and so on*

*

Total of these individual customer accounts must equal $38,100.

The allowance method results in the following presentation in the Compuport balance sheet at December 31, 20X1: Accounts receivable Less: Allowance for uncollectible accounts Net accounts receivable

$40,000 2,000 $38,000

Oracle discloses its allowance for uncollectible accounts in the caption for Trade Receivables: ($ in millions) Trade receivables, net of allowances for doubtful accounts of $372 and $305 as of May 31, 2011 and 2010, respectively

2011

2010

$6,628

$5,585

The allowance method relies on historical experience and information about economic circumstances (growth versus recession, interest rate levels, and so on) and customer composition. Of course, companies revise estimates when conditions change. For example, if a local employer closed or drastically reduced employment and many local customers were suddenly unemployed, Compuport might increase expected bad debts. Oracle discloses the following in its 2011 annual report: We record allowances for doubtful accounts based upon a specific review of all significant outstanding invoices. For those invoices not specifically reviewed, provisions are provided

MEASUREMENT OF UNCOLLECTIBLE ACCOUNTS

253

at differing rates, based upon the age of the receivable, the collection history associated with the geographic region that the receivable was recorded in and current economic trends. We write-off a receivable and charge it against its recorded allowance when we have exhausted our collection efforts without success. We next examine three methods of estimating bad debts when applying the allowance method.

Applying the Allowance Method Using a Percentage of Sales How do managers and accountants estimate the amount of bad debts in the allowance method? Companies that express the amount as a percentage of total credit sales use the percentage of sales method, which relies on historical relationships between credit sales and uncollectible accounts adjusted for current economic conditions. This method is often referred to as an income statement approach because the computation of bad debt expense is a function of an income statement value, credit sales, not a function of the balance in Accounts Receivable. It was the method used in the previous section that introduced the allowance method. In our example, Compuport managers determined a rate of 2% of credit sales, for a total of (2% × $100,000) = $2,000, based on experience. To arrive at the 2% rate they might look at the last 4 years and divide the total of all bad debts by the total of all credit sales to calculate that over time they failed to collect 2% of credit sales.

percentage of sales method An approach to estimating bad debt expense and uncollectible accounts based on the historical relationship between credit sales and uncollectible accounts adjusted for current economic conditions.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S How does the ultimate write-off of the Monterro and Jones accounts affect total assets reported on the balance sheet?

Answer The ultimate write-off has no effect on total assets:

Before After Write-Off Write-Off Accounts receivable Allowance for uncollectible accounts Book value (net realizable value)

$40,000

$38,100

2,000 $38,000

100 $38,000

Applying the Allowance Method Using a Percentage of Accounts Receivable A second method of estimating the amount of bad debts is the percentage of accounts receivable method, which bases estimates of uncollectible accounts on the historical percentage of ending accounts receivable that subsequently prove to be uncollectible, not on the percentage of credit sales that become uncollectible. This method focuses on the ending Accounts Receivable balance and estimates the percentage of those receivables that is unlikely to be collected. As a result of this focus on the ending accounts receivable balance, we refer to this method as a balance sheet approach. The Allowance for Uncollectible Accounts contra account should show the estimated amount of bad debts contained in the end-of-period accounts receivable, that is, the bad debt percentage multiplied by the ending accounts receivable. We then calculate the needed adjustment to the Allowance for Uncollectible Accounts to achieve the desired ending balance in the Allowance account. Consider the historical experience in the following table: Accounts Receivable at End of Year 20X1 20X2 20X3 20X4 20X5 20X6 Six-year total

Bad Debts Deemed Uncollectible and Written Off in Subsequent Year

$100,000 80,000 90,000 110,000 120,000

$ 3,500 2,450 2,550 4,080 5,600

112,000 $612,000

2,200 $20,380

Average percentage not collected = ($20,380 ÷ $612,000) = 3.33%

percentage of accounts receivable method An approach to estimating bad debt expense and uncollectible accounts that bases estimates of uncollectible accounts on the historical percentage of ending accounts receivable that subsequently prove to be uncollectible.

254

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At the end of 20X7 the accounts receivable balance is $115,000. We compute the 20X7 addition to the Allowance for Uncollectible Accounts as follows: 1. Divide total bad debt losses of $20,380 by total ending accounts receivable of $612,000 to calculate the historical average uncollectible percentage of 3.33%. 2. Apply the percentage from step 1 to the ending Accounts Receivable balance for 20X7 to determine the ending balance that should be in the Allowance account at the end of the year: (3.33% × $115,000) = $3,830. 3. Prepare an adjusting entry to bring the Allowance to the appropriate amount determined in step 2. Suppose that, prior to the adjusting entry, the books show a $700 credit balance in the Allowance account at the end of 20X7. Then the adjusting entry needed for 20X7 is ($3,830 – $700), or $3,130, to record the Bad Debt Expense. The journal entry is as follows: Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for uncollectible accounts . . . . . . . . To bring the Allowance to $3,830, the level justified by bad debt experience during past 6 years

3,130 3,130

The percentage of accounts receivable method differs from the percentage of sales method in two ways: (1) The percentage is based on the ending accounts receivable balance instead of credit sales, and (2) the dollar amount calculated using the percentage is the appropriate ending balance in the allowance account, not the amount added to the account for the year.

Applying the Allowance Method Using the Aging of Accounts Receivable aging of accounts receivable method An approach to estimating bad debt expense and uncollectible accounts that considers the composition of year-end accounts receivable based on the age of the debt.

EXHIBIT 6-2 Compuport Aging of Accounts Receivable, 20X7

We can refine the percentage of accounts receivable approach by considering the composition of the end-of-year accounts receivable based on the age of the debt. This aging of accounts  receivable method directly incorporates the customers’ payment histories. As more time elapses after the sale, collection becomes less likely. The seller may send the buyer a late notice 30 days after the sale and a second reminder after 60 days, make a phone call after 90 days, and place the account with a collection agency after 120 days. Companies that analyze the age of their accounts receivable for credit management purposes naturally incorporate this information into accounting estimates of the allowance for uncollectibles. For example, the $115,000 balance in Accounts Receivable on December 31, 20X7, for Compuport might be aged as shown in Exhibit  6-2. Experience has shown that only 0.1% of receivables less than 30 days old become uncollectible, while 1% of those between 31 and 60 days, 5% of those between 61 and 90 days, and 90% of those over 90 days old are ultimately not collected. We can apply these percentages to the outstanding balance in receivables in each age category to estimate that Compuport will not collect $3,772 of the $115,000 accounts receivable. This aging schedule in Exhibit 6-2 produces a different target balance for the Allowance account than the balance that resulted from the percentage of accounts receivable method: $3,772 versus $3,830. Therefore, the journal entry is slightly different. Given the same

Name

Total

1–30 Days

31–60 Days

61–90 Days

More Than 90 Days

$1,000 2,000 $3,000 90%

Oxwall Tools Chicago Castings Estee Sarasota Pipe Ceilcote Other accounts (each detailed) Total

$ 20,000 10,000 20,000 22,000 4,000 39,000

$20,000 10,000 15,000

27,000

8,000

$10,000 3,000 2,000

$115,000

Historical bad debt percentages Bad debt allowance to be provided

$72,000 0.1%

$25,000 1%

$15,000 5%

$

3,772

=

$

72

$ 5,000 12,000

+ $

250

+ $

750

+

$2,700

MEASUREMENT OF UNCOLLECTIBLE ACCOUNTS

255

$700 credit balance in the Allowance account, the journal entry to record the Bad Debt Expense is ($3,772 – $700) = $3,072: Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . Allowance for uncollectible accounts. . . . . . . . . . To bring the Allowance to $3,772, the level justified by prior experience using the aging method

3,072 3,072

Whether a company uses the percentage of sales, percentage of accounts receivable, or aging of accounts receivable method to estimate bad debt expense and the Allowance for Uncollectible Accounts, the subsequent accounting for write-offs is the same—a decrease in Accounts Receivable and a decrease in the Allowance for Uncollectible Accounts.

Bad Debt Recoveries and the Allowance Method Now let’s consider bad debt recoveries under the allowance method. As described on p. 250, we reverse the write-off and then handle the collection as a normal receipt on account. Return to the earlier Compuport example and assume that we wrote off Monterro’s account for $500 in February 20X2 and then unexpectedly collected it in January 20X3. The following journal entries produce a complete record of the transactions in Monterro’s individual accounts receivable account: 20X1

Feb. 20X2

Jan. 20X3

Accounts receivable, Monterro . . . . . . . . . . . . . . . . Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . To record sales of $500 to Monterro, a specific customer Allowance for uncollectible accounts. . . . . . . . . . . . Accounts receivable, Monterro. . . . . . . . . . . . . To write off uncollectible account of Monterro Accounts receivable, Monterro . . . . . . . . . . . . . . . . Allowance for uncollectible accounts . . . . . . . . To reverse February 20X2 write-off of account of Monterro Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable, Monterro. . . . . . . . . . . . . To record the collection on account

500 500

500 500 500 500

500 500

Note that these 20X2 and 20X3 entries have no effect on the level of bad debt expense estimated for 20X1. At the end of 20X1, using one of the three estimation methods we just examined, Compuport estimated bad debt expense and end-of-period uncollectibles. We do not change these estimates, even if future uncollectibles are greater or less than expected. The errors in estimate affect future periods but do not produce adjustments of prior periods.

I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S Examine the trade receivables balances of Oracle as of May 31, 2011 and 2010, shown on page 252. Compute the gross accounts receivable on May 31, 2011 and 2010. Did the percentage of accounts receivable deemed uncollectible increase or decrease in 2011?

Answer Oracle’s gross accounts receivable balances were as follows:

2011: 2010:

$6,628 million + $372 million = $7,000 million; $5,585 million + $305 million = $5,890 million.

In 2010, Oracle deemed ($305 ÷ $5,890) = 5.18% of the accounts receivable to be uncollectible; in 2011 it was ($372 ÷ $7,000) = 5.31%. Therefore, the company expected a slightly higher default percentage in 2011 than in 2010. The change may have resulted from a change in actual experience or may have resulted from the company’s belief that the continuing recession would cause default rates to increase.

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BUSINESS FIRST M A N A G I N G A C C O U N T S R E C E I VA B L E Years ago, a current ratio (current assets ÷ current liabilities) of 2 to 1 was normal, but increasingly aggressive companies have driven their current ratios below 1. This is not accidental. It happens because these companies view most current assets as money that is not available to help expand the company. To reduce the current ratio, companies are concentrating on reducing current assets, including accounts receivable. However, reductions in accounts receivable must not undermine the company’s relationships with its customers. Cash and receivables management involves careful planning of receipts and disbursements. When you can accurately predict future cash flows, you avoid the need to keep idle cash “just in case.” Many companies find their major problem in collecting receivables is disputes over amounts billed. If companies discover disputes when a bill is overdue and lose more time in solving the problem, significant payment delays result. One solution is to provide records on a Web site so customers can see exactly what the selling company has recorded. Early contact between the seller’s accounts receivable staff and the buyer’s accounts payable staff

may promptly resolve disputes. Well-managed companies are glad to work closely with customers and suppliers to complete their business in a timely and accurate manner. Burlington Northern Santa Fe, the railroad company with nearly $20 billion of revenue and $70 billion of assets, speeded collection by breaking its receivable management into two steps. What it calls “days-to-bill” measures the time between providing service and billing the customer, whereas “days-to-pay” measures the time between billing and collection. To reduce days-to-bill, the company executed technology initiatives to eliminate errors and get the billing process out of human hands. It reduced bills in process on any given day to 15,000 from about 50,000 a decade earlier. By working closely with customers to resolve disputes, the company also cut its collection period significantly; in 2011 the company collected receivables in an average of 19 days compared with more than 30 days a decade earlier. Sources: R. Myers, “Cash Crop: The 2000 Working Capital Survey,” CFO Magazine, August 2000; Burlington Northern Santa Fe Corporation 2011 Annual Report.

Assessing the Level of Accounts Receivable  OBJECTIVE 4 Assess the level of accounts receivable.

accounts receivable turnover Credit sales divided by average accounts receivable for the period during which the sales are made.

In addition to accounting properly for bad debts, managers seek to manage bad debt levels appropriately. The more credit a company provides, the greater the sales but also the greater the chances of bad debts occurring. Management and financial analysts ask questions such as the following: Can the firm increase sales without excessive growth in receivables? Do bad debt expenses rise sharply when sales grow, indicating a reduction in the credit quality of the company’s customers? The secret to managing accounts receivable is to allow enough credit to facilitate sales but not allow collections to lag and receivables to build up, as illustrated in the Business First box above. One measure of the ability to control receivables is the accounts receivable turnover— credit sales divided by the average accounts receivable for the period during which the sales were made: Accounts receivable turnover = Credit sales , Average accounts receivable This ratio indicates how rapidly collections occur. Suppose you made $100 in credit sales each day, 365 days per year, and you collected cash for every sale 10 days after the sale. In this instance, annual credit sales would be (365 × $100) = $36,500, and average accounts receivable would be (10 days × $100 per day) = $1,000, giving an accounts receivable turnover of ($36,500 ÷ $1,000) = 36.5. If the turnover were 12, it would indicate that, on average, the company collects receivables after 1 month. Higher turnovers indicate that a company collects its receivables quickly—lower turnovers indicate slower collection cycles. Competitive conditions in the industry often drive the ratio. Changes in the ratio provide important guidance concerning

ASSESSING THE LEVEL OF ACCOUNTS RECEIVABLE

changes in the company’s policies, changes in the industry’s competitive environment, and changes in general economic conditions. For example, a decline in the general level of economic activity will slow collections across the board, and this turnover measure will tend to decline for all firms. Suppose credit sales for Compuport in 20X8 were $1 million and beginning and ending accounts receivable were $115,000 and $112,000, respectively. The accounts receivable turnover ratio would be computed as: Accounts receivable turnover = $1,0000,000 , 31>2 * ($115,000 + $112,000)4 = 8.81 We can also assess receivables levels in terms of how many days it takes to collect them. This alternative to the turnover ratio has an appealing direct interpretation. How long does it take on average to get my money after I make a sale? The days to collect accounts receivable, or average collection period, is 365 divided by the accounts receivable turnover. For our example, Days to collect accounts receivable = 365 days , Accounts receivable turnover = 365 days , 8.81 = 41.4 days When we try to compare accounts receivable turnover or average collection period across companies, we encounter a major problem. Companies do not disclose their credit sales, only total sales. Thus, computations available to the public are generally based on total sales. This means that two factors affect accounts receivable turnover and average collection period, the percentage of sales that are on credit and the credit collection experience. For example, jewelry retailers take twice as long to collect receivables as do bookstores. But this may be due more to the fact that jewelers have a larger percentage of sales on credit rather than a difference in experience in collecting accounts receivable. Nevertheless, managers, who have access to credit sales data, can use these measures to monitor the success of their collection efforts.

Summary Problem for Your Review PROBLEM The balance sheet of VF Corporation, the large apparel company with brands such as JanSport, Nautica, Wrangler, Lee, and The North Face, showed accounts receivable at December 31, 2011, of $1,120,246,000, net of allowances of $54,010,000. Suppose a large discount chain that owed VF $8 million announced bankruptcy on January 2, 2012. VF managers decided that chances for collection were virtually zero and immediately wrote off the account. Show the accounts receivable and allowance account balances after the write-off, and explain the effect of the write-off on income for the year beginning January 1, 2012.

SOLUTION The write-off does not affect the net accounts receivable. Nevertheless, both gross accounts receivable and the allowance for doubtful accounts change. Gross accounts receivable were $1,174,256,000 at January 2 and the allowance was $54,010,000, giving a net accounts receivable of $1,120,246,000. When VF takes the write-off, gross accounts receivable decrease by $8 million, but the allowance does also, with the following result: Gross receivables ($1,174,256,000 – $8,000,000) Less: Allowance for doubtful accounts ($54,010,000 – $8,000,000) Net receivables

There would be no effect on VF Corporation’s 2012 net income.

$1,166,256,000 46,010,000 $1,120,246,000

days to collect accounts receivable (average collection period) 365 divided by accounts receivable turnover.

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Accounting for and Managing Cash OBJECTIVE 5 Manage cash and explain its importance to the company.

All revenues are expected to generate cash at some point. We next discuss the reporting and managing of cash. Many companies combine cash and cash equivalents on their balance sheets. Recall that cash equivalents are highly liquid short-term investments that can easily and quickly be converted into cash. For example, the 2011 balance sheet of Oracle begins with “Cash and cash equivalents … $16,163 million.” Oracle describes its cash equivalents as “deposits held at major banks, money market funds, Tier 1 commercial paper, corporate notes, U.S. Treasury obligations, U.S. government agency and government sponsored enterprise obligations, and other securities with original maturities of 90 days or less.” Although this is a long complex list of items, they all share one characteristic: Oracle will have cash in hand when the securities mature (within no more than 90 days), or Oracle can easily sell these marketable items to other people and receive cash immediately. Cash means the same thing to organizations that it does to individuals. It is not just paper money and coins, but it also includes other items that a bank will accept for deposit, including money orders and checks. However, banks do not treat all items accepted for deposit the same. For example, although a bank may add all deposits to the accounts of bank customers on the date received, the bank may not provide the depositor with access to the funds until the check “clears” through the banking system (until the bank receives payment from the check writer’s bank). If the check fails to clear because its writer has insufficient funds, the bank deducts the amount of the check from the depositor’s account. A bank employee may talk about a deposit being “credited” to the account of a customer of the bank. A manager of the company making the deposit may be confused by the term “credited.” He regarded the deposit as a debit to cash. Why would a banker say the customer’s account is “credited"? Deposits in the bank are assets to the depositor but they are a liability to the bank. Suppose a company receives a check from a customer and deposits the check in its bank account. The company debits its Cash account (an asset account) to show the increase in the asset Cash. The offsetting credit might be to Sales if the check came from a sales transaction or to Accounts Receivable if it arose from collection of an account. In contrast, when the bank receives the check, it credits its liability account Deposits to acknowledge the increase in the amount it owes the company depositing the check.

Compensating Balances compensating balances The required minimum balances a company must keep on deposit designed to partially compensate the bank for providing a loan to the company.

Frequently, the entire cash balance in a bank account is not available for unrestricted use. Why? Because banks often require companies to maintain compensating balances, which are required minimum balances on deposit designed to partially compensate the bank for providing a loan to the company. Compensating balances increase the effective interest rate that the borrower pays. For a loan of $100,000 at 8% per year, the annual interest will be $8,000. With a 10% compensating balance, the borrower can use only $90,000 of the loan, raising the effective interest rate on the usable funds to ($8,000 ÷ $90,000) = 8.9%. To ensure that financial statements provide a true picture concerning cash, annual reports must disclose significant compensating balances. For example, a footnote in the annual report of Chiquita Brands International, the distributor of Chiquita and Fresh Express brand produce, disclosed the following: “The company had €5 million ($6 million) … of cash equivalents in a compensating balance arrangement… .” Without such disclosures, analysts and investors might think that a company has more cash available than it really does.

Management of Cash Cash is usually a small portion of the total assets of a company. Yet, companies manage cash especially carefully. Why? First, although the cash balance may be small at any one time, the flow of cash can be enormous. Weekly receipts and disbursements of cash may be many times as large as the cash balance. Second, because cash is the most liquid asset, it is enticing to thieves and embezzlers. If someone steals a $200 jacket, he or she may be able to get only $40 from selling stolen goods, but if the same person steals $200 cash, he or she will have $200. Third, adequate cash is essential to the smooth functioning of operations. Companies need it

OVERVIEW OF INTERNAL CONTROL

for everything from routine purchases to major investments, from purchasing lunch for a visiting business partner to purchasing another company. Finally, because cash itself does not earn income, it is important not to hold excess cash. The treasury department is responsible for managing the levels of cash efficiently and for ensuring that the company deposits unneeded cash in income-generating accounts. Most organizations have detailed, well-specified procedures for receiving, recording, and disbursing cash. These are part of an organization’s internal control system (or internal controls), which provides checks and balances that ensure all company actions are proper and are consistent with management’s goals and objectives. Internal control of cash is especially important because of its vulnerability to theft or embezzlement. Companies should have a policy to immediately deposit cash in a bank account, and they should periodically reconcile the company’s books with the bank’s records. To reconcile a bank statement means to verify that the bank balance and the accounting records are in agreement. The two balances are rarely identical. A company records a deposit when it sends money to the bank and records a payment when it writes a check. The bank, however, records the deposit when it is received, probably a day or two after the company recorded it. The bank typically receives and processes a check written by a company when the payee deposits it and it clears through the banking system, possibly days or weeks after the company issues it. For more on bank reconciliations see Appendix 6. Additional internal control procedures set up to safeguard cash include the following:

259

internal control system (internal controls) Checks and balances that ensure all company actions are proper and are consistent with top management’s goals and objectives.

reconcile a bank statement To verify that the bank balance for cash is in agreement with the accounting records.

1. 2. 3. 4.

Have different individuals receive cash than those who disburse cash. Have different individuals handle cash than those who access accounting records. Immediately record and deposit cash receipts. Make disbursements using serially numbered checks and require proper authorization by someone other than the person writing the check. 5. Reconcile bank accounts monthly. Why are such internal controls necessary? Consider a person who handles cash and makes entries into the accounting records. That person could take $200 in cash and cover it up by making the following entry in the books: Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

200 200

Besides guarding against dishonest actions, internal control procedures help ensure that accounting records are accurate. For example, suppose a company writes a check but does not record it in the books. The bank reconciliation will not balance. With serially numbered checks, it is possible to trace items from the checkbook to a bank statement and identify the unrecorded check.

Overview of Internal Control Companies design internal control systems to protect all their assets, not just cash, and to help managers maintain accurate financial records. For example, we do not want a manager to expose the company to huge speculative losses from unauthorized trading of exotic derivative securities. Here internal controls ensure that managers make decisions consistent with corporate strategy. Nor should a salesperson at a clothing store be able to walk out of the store with holiday gifts for the family without paying for them. Here internal control refers to the protection of firm assets from theft and loss. An electronic tag on a leather coat is an internal control device and so is the requirement that two people have to approve checks over $5,000. In its broadest sense, internal controls refer to both administrative controls and accounting controls: 1. Administrative controls are methods and procedures that facilitate management planning and control of operations. They include the formal organizational chart that spells out responsibilities and reporting relationships, as well as departmental budgeting procedures, reports on performance, and procedures for granting credit to customers.

OBJECTIVE 6 Develop and explain internal control procedures.

administrative controls All methods and procedures that facilitate management planning and control of operations.

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accounting controls The methods and procedures for authorizing transactions, safeguarding assets, and ensuring the accuracy of the financial records.

2. Accounting controls include the methods and procedures for authorizing transactions, safeguarding assets, and ensuring the accuracy of the financial records. Good accounting controls help to maximize efficiency and to minimize waste, errors, and fraud. We focus on internal accounting controls, which have the following objectives: 1. Authorization. Ensure that managers execute transactions in accordance with management’s general or specific intentions. 2. Recording. Ensure that accountants accurately record authorized transactions. 3. Safeguarding. Provide appropriate restrictions on access to assets. 4. Reconciliation. Ensure that accountants regularly verify records against other independently kept records and/or confirm them by physical counts or examinations. 5. Valuation. Ensure that accountants periodically review recorded amounts for impairment of values and necessary write-downs. 6. Operational Efficiency. In addition to preventing errors and fraud, good internal control systems promote efficient actions. The first three general objectives—authorization, recording, and safeguarding—relate to a system of accountability to prevent errors and irregularities. The fourth and fifth objectives— reconciliation and valuation—aid in detecting errors and irregularities. The last objective recognizes that an internal control system’s purpose is as much a positive one (promoting efficiency) as a negative one (preventing errors and fraud).

The Accounting System An entity’s accounting system is a set of records, procedures, internal controls, and equipment that collect, organize, and report the continuous flow of information about the events affecting the entity’s financial performance and position. Chapters 3 and 4 provided an overview of the heart of the accounting system—including source documents, journal entries, postings to ledgers, trial balances, adjustments, and financial reports. The system handles repetitive, voluminous transactions, which fall primarily into four categories: 1. 2. 3. 4.

Cash disbursements Cash receipts Purchase of goods and services, including employee payroll Sales and delivery of goods and services

The volume of the physical records is often staggering. For example, telephone and credit card companies process millions of transactions daily. Computers and data processing systems make it possible. Well-designed and well-run accounting systems are positive contributions to organizations and the economy. Credit card companies, for example, use sophisticated systems to evaluate transactions on your credit card and may refuse a credit transaction that seems likely to be a fraudulent use of your card by an unauthorized party. Although such refusals sometimes inconvenience a legitimate card holder, they more frequently foil criminal use. Another example is FedEx Corporation, which created a dominant position in the overnight delivery market by developing an efficient system for continuously tracking items from pickup to delivery. Finally, Wal-Mart’s extraordinary success as a low-price retailer is due in part to its integrated inventory control and ordering system that allows its computers to interact automatically with suppliers, whether they are companies such as Procter & Gamble in the United States or Shenzhen Zuonmens Industrial in China, to generate orders and reduce delivery times.

Checklist of Internal Control Good systems of internal control have certain features in common. We have summarized these features in a checklist of internal control—the best practices that managers use to create or evaluate specific procedures for cash, purchases, sales, payroll, and the like. 1. Reliable Personnel with Clear Responsibilities. The most important control element is personnel. Incompetent or dishonest individuals undermine any system. Thus, good procedures to hire, train, motivate, and supervise employees are essential. Companies should give individuals authority, responsibility, and duties commensurate with their abilities, interests, experience, and reliability. Employees should be evaluated periodically against their responsibilities.

OVERVIEW OF INTERNAL CONTROL

The wrong, lowest-cost talent is expensive in the long run, not only because of fraud but also because of poor productivity. Clear responsibilities means having policies and procedures that specify such details as having sales clerks sign sales slips, inspectors sign initial packing slips, and workers sign time cards and requisitions. For example, grocery stores often assign each cashier a separate money tray so management can reward efficiency and easily trace shortages. It has been estimated that retailers lose more than 2% of sales to theft and mistakes—and employee theft causes much larger losses than shoplifting. 2. Separation of Duties. Separation of duties makes it hard for one person, acting alone, to defraud the company. This is why large movie theaters have a cashier selling tickets and an usher taking them. The cashier takes in cash, the usher keeps the ticket stubs, and a third person compares the cash with the number of stubs. However, separation of duties is not foolproof. Suppose the ticket seller pockets the cash and issues a fake ticket. If the ticket seller and usher collude, the usher might accept the fake ticket, destroy it, and allow entry. Separation of duties alone does not prevent such collusive theft. Better supervision of the ticket seller and the usher is the primary method of preventing such collusion. Or, even in the absence of collusion, if the fake ticket is a good forgery, the usher may not be able to detect the ticket seller’s theft. Here are two examples where separation of duties would lead to better internal control: • In a computer system, a person with custody of assets should not have access to programming or any input of records. In a classic example, a programmer in a bank rounded transactions to the next lower cent instead of the nearest cent and had the computer put the fraction of a cent into his account. A customer amount of $10.057 became $10.05, and the programmer’s account received $.007. With millions of transactions, the programmer’s account grew very large. • The same individual should not authorize payments and also sign the check in payment of the bill. Similarly, an individual who handles cash receipts should not have the authority to indicate which accounts receivable should be written off as uncollectible. The latter separation of powers prevents the following embezzlement: A bookkeeper opens the mail, removes a $1,000 check from a customer, and somehow cashes it. To hide the theft, the bookkeeper prepares the following journal entry to write off an amount owed by a customer: Allowance for bad debts . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . . . . . .

1,000 1,000

3. Proper Authorization. General authorizations are usually written policies, such as definite limits on what price to pay (whether to fly economy or first class), on what price to receive (whether to offer a sales discount), on what credit limits to grant to customers, and so forth. Specific authorizations require that a designated manager explicitly approve deviations from the limits set by general authorization. For example, a senior manager may need to approve overtime or the board of directors may need to approve large expenditures for capital assets. 4. Adequate Documents. Companies have a variety of documents and records, from source documents (such as sales invoices and purchase orders) to journals and ledgers. Immediate, complete, and tamper-proof recording of data is the goal. Companies minimize recording errors by optically scanning bar-coded data, by prenumbering and accounting for all source documents, by using devices such as cash registers, and by designing forms for ease of recording. When a merchant offers a customer a free item if a red star comes up on the cash register receipt, it is partly a way to ensure that sales clerks actually ring up the sale and charge the proper amount. 5. Proper Procedures. Most organizations use procedure manuals to specify the flow of documents and provide information and instructions to facilitate record keeping. Well-designed routines permit specialization of effort, division of duties, and automatic checks on each step in the routine. 6. Physical Safeguards. Companies minimize losses of cash, inventories, and records by using safes, locks, guards, guard dogs, and special lighting and limiting access to sensitive areas. For example, many companies require all visitors to sign a register and wear a name tag, and they may restrict access to certain places by having card scanners that grant admission only to authorized personnel.

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BUSINESS FIRST LACK OF INTERNAL CONTROLS AND THE $346,770 OVERDRAFT Banks need tight internal controls on their ATMs because they dispense cash. This is important not only to protect cash but also to maintain customer confidence. Think about how bank internal control procedures should stop potential thieves. Automated teller machines (ATMs) require the use of a customer’s personal identification number (the “pin” number). As a secondary precaution, ATMs normally restrict withdrawals to a maximum amount, perhaps $300 per day, per account. To keep thieves from randomly guessing pin numbers, computers track “unauthorized” accesses. After several incorrect pin numbers, the ATM keeps the card and notifies the user to reclaim it at the bank. Given such controls, how could someone take $346,770 from Karen Smith’s bank account via ATMs? It all started when she left her bank card in her wallet, which was locked inside her van during a high school football game. Two thieves broke into the van, stole the bank card, and started visiting local ATMs. Karen’s big mistake was storing her pin number on her social security card, which she kept in the stolen wallet. But that alone was not enough. Oregon TelCo Credit Union happened to be updating some computer programs, and its $200 limit per account per day was inoperative—a severe lapse in controls. To access all the

funds in Karen’s account, the thieves put the card in and withdrew $200, time after time. When one ATM ran out of bills, the thieves visited another on a circuitous, fivecounty, 500-mile route. Another internal control should have limited the thieves to the balance in Karen’s account, which was much less than $346,770. Something else went wrong. Banks generally do not allow access to deposits made in an ATM until at least the next banking day so the bank can verify the deposit. Unfortunately, the TelCo system was giving immediate credit for deposits made into automated tellers. The thieves “deposited” $820,500 by inserting empty deposit envelopes and recording large deposits on the ATM keypad. They exhausted the cash in the ATMs in their five-county area by 2:30  AM and headed to Reno to buy a new truck and enjoy their wealth. One piece of TelCo’s internal control worked. Hidden cameras photographed the thieves. From the videos, the police were able to identify and arrest the perpetrators, a husband and wife team with more than 20 felony convictions between them. Sources: “Survey: Level Four Finds ATM Security Is Top Concern for U.S. Consumers,” ATMmarketplace.com, February 17, 2009; New York Times, February 12, 1995, p. 36.

7. Vacations and Rotation of Duties. Rotating employees and requiring them to take vacations ensures at least two employees know how to do each job so an absence due to illness or a sudden resignation does not create major problems. Further, employees are less likely to engage in fraudulent activities if they know that another employee periodically performs their duties and might discover the fraud. A company might accomplish rotation of duties by the common practice of having employees such as receivables and payables clerks occasionally exchange duties. In addition, a receivables clerk may handle accounts from A to C for 3 months, and then be rotated to accounts M to P for 3 months, and so forth. 8. Independent Check. All phases of the system should undergo periodic review by outsiders such as independent public accountants or internal auditors. By first evaluating the system of internal control and testing the extent to which employees follow the appropriate procedures, the auditor decides on the likelihood of undetected errors. When internal controls are weak, auditors will examine many transactions to provide reasonable assurance that they discover errors if any exist. If internal controls are strong, the auditor can use a smaller sample to develop confidence in the accuracy of the accounting records. 9. Cost-Benefit Analysis. Highly complex systems can strangle people in red tape, impeding instead of promoting efficiency. The right investments in the accounting system can produce huge benefits. No internal control is perfect, but adequate internal control is essential, as illustrated in the Business First box above. The goal is not total prevention of fraud or implementation of operating perfection; instead, the goal is the design of a cost-effective tool that helps achieve efficient operations and minimizes temptation.

HIGHLIGHTS TO REMEMBER

263

Reports on Internal Controls The Sarbanes-Oxley Act requires U.S. companies to publicly report on the adequacy of their internal controls. In addition, the company’s auditor must also issue a report attesting to management’s assessment. Oracle reported the following about its internal controls in its 2011 10-K report to the SEC: Our management is responsible for establishing and maintaining adequate internal control over financial reporting . . . [W]e conducted an evaluation of the effectiveness of our internal control over financial reporting as of May 31, 2011 . . . . Our internal control over financial reporting includes policies and procedures that provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with U.S. generally accepted accounting principles . . . . The effectiveness of our internal control over financial reporting as of May 31, 2011, has been audited by Ernst & Young LLP, an independent registered public accounting firm. THE AUDIT COMMITTEE Management’s responsibility for the entity’s financial statements and

internal controls extends upward to the board of directors. In the United States the SEC requires publicly traded companies to have an audit committee, which oversees the internal accounting controls, financial statements, and financial affairs of the corporation. While audit committees are not required everywhere, their use is increasing throughout the world. Audit committees provide contact and communication among the board, the external auditors, the internal auditors, the financial executives, and the operating executives. Audit committee members in the United States must be “outside” board members, that is, board members who are not managers of the company. They are considered to be more independent than the “inside” directors—employees who serve as part of the corporation’s management. Oracle has a typical board composition. Of its twelve directors in 2012, four are also members of management (including founder and CEO Lawrence Ellison) and eight are “outside” directors— four executives or retired executives from other companies, two academics, a consultant, and a venture capitalist. Oracle has a combined Finance and Audit Committee that includes only outside directors. It met 17 times in 2011, more than any other board committee.

Highlights to Remember

1

Recognize revenue items at the proper time on the income statement. Companies currently recognize revenue when a sale meets two criteria: (1) the revenue is earned, and (2) the asset received in return is realized or realizable. A proposed new standard may change this to eliminate the formal realization criterion. The new standard would also spread the recognition of revenue over time when products or services are not all transferred to the customer at the point of sale. Nevertheless, the most common situation is one where delivery of the product and recognition of revenue both occur at the point of sale. Account for sales, including sales returns and allowances, sales discounts, and bank credit card sales. At the moment a sale occurs and meets the revenue recognition requirements, a company records the full amount of the sale. This allows the sales revenue for the year to show the full level of economic activity, regardless of whether the sale is on account or for cash. The sale increases an asset account and increases the sales revenue account. For credit sales we also need to maintain a subsidiary ledger that contains detailed records about the individual customers and the amounts owed by each customer. In addition, a company may not collect the total sales it initially recorded. It may offer various discounts or allowances, which it deducts from gross sales to arrive at net sales on the income statement. Sales returns and allowances arise when customers return merchandise or receive discounts due to damaged goods or errors in filling the order. Customers sometimes receive a cash discount as a result of prompt payment. Similarly, bank cards charge a known discount or service fee to compensate the bank for its collection services. One type of discount, a trade discount, is not deducted from gross sales to get net sales but is a reduction in gross sales itself.

2

audit committee A committee of the board of directors that oversees the internal accounting controls, financial statements, and financial affairs of the corporation.

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3

Estimate and interpret uncollectible accounts receivable balances. Potential uncollectible accounts reduce the amount of accounts receivable reported on the balance sheet. Reporting the uncollectible portion of credit sales requires estimates that may be based on a percentage of credit sales, a percentage of accounts receivable, or an aging of accounts receivable. These estimates permit the financial statements to (1) properly reflect asset levels on the balance sheet, and (2) properly match bad debt expense with revenue on the income statement. Assess the level of accounts receivable. Companies and analysts use ratios to assess the level of accounts receivable. The accounts receivable turnover ratio and the days to collect accounts receivable both relate the balance in accounts receivable to the level of credit sales during the year. Comparisons with other companies is problematic because companies do not disclose credit sales. However, examination of a particular company over time draws attention to unusual circumstances and possible problems. Manage cash and explain its importance to the company. Cash is the fuel that runs a company and must be available to meet obligations as they come due. Managing cash requires vigilance. Protecting cash from theft or loss, adequately planning for the availability of cash as needed, and reconciling the firm’s accounting records with the bank’s records are just some of the issues management must address. Develop and explain internal control procedures. It is tempting to delegate internal control decisions to accountants. However, managers at all levels have a major responsibility for the success of internal controls. To help monitor internal control, boards of directors appoint audit committees, which oversee accounting controls, the financial statements, and general financial affairs of the company. Managers and accountants should recognize that the role of an internal control system is as much a positive one (enhancing efficiency) as a negative one (reducing errors and fraud). A checklist for effective internal control includes the following: (1) reliable personnel with clear responsibilities, (2) separation of duties, (3) proper authorization, (4) adequate documents, (5) proper procedures, (6) physical safeguards, (7) vacations and rotation of duties, (8) independent check, and (9) cost-benefit analysis.

4 5 6

Appendix 6: Bank Reconciliations  OBJECT IVE 7 Prepare a bank reconciliation.

An important part of internal control of cash is to reconcile bank statements. The top part of Exhibit 6-3 shows the cash transactions during January 20X2 for Ruiz Company and its bank, Bank of America, in a T-account format. The bottom part of the exhibit lists Ruiz Company’s journal entries for its cash transactions. The cash balance on January 31 is an asset (Cash in Bank, a receivable from the bank) of $8,000 on the depositor’s books and a liability (Deposits, a payable to the depositor) of $10,980 on the bank’s books. The purpose of a bank reconciliation is to explain the differences between the bank’s balance and the depositor’s balance. First, let’s review how banks use the terms debit and credit. Banks credit the depositor’s account for additional deposits because the bank has a liability to the depositor and the bank’s credit entry increases its liability. Banks debit the account for checks written by the depositor and paid by the bank because they reduce the bank’s liability to the depositor. For example, on January 8, when the bank pays the $2,000 check drawn by the depositor on January 5, the bank’s journal entry would be as follows: Jan. 8

Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . To decrease the depositor’s account

2,000 2,000

Ruiz Company performs a monthly bank reconciliation to make sure the company and the bank have recorded the same deposits and withdrawals. Reconciliations also ensure that the depositor has recorded all fees and charges and any direct deposits recorded by the bank. Bank reconciliations take many forms, but the objective is to explain all differences in the cash balances shown on the bank statement and in the depositor’s general ledger at a given date. Exhibit 6-4 is Ruiz’s bank reconciliation for January using the data in Exhibit 6-3.

APPENDIX 6: BANK RECONCILIATIONS

EXHIBIT 6-3 Cash Transactions January 20X2 Ruiz Company Records Cash in Bank 1/1/X2 Bal.

11,000

1/5

2,000

1/10

4,000

1/15

3,000

1/24

6,000

1/19

5,000

7,000

1/29

1/31

28,000 1/31/X2 Bal.

10,000 20,000

8,000 Bank of America Records Deposits

1/8

2,000

1/1/X2 Bal.

11,000

1/20

3,000

1/11

4,000

1/28

5,000

1/26

6,000

20*

1/31

10,020

21,000 1/31/X2 Bal.

10,980

*

Service charge for printing checks.

Ruiz Company General Journal Date 1/5

Debit Accounts payable

Credit

2,000

Cash

2,000

Check No. 1 1/10

Cash

4,000

Accounts receivable

4,000

Deposit slip No. 1 1/15

Income taxes payable

3,000

Cash

3,000

Check No. 2 1/19

Accounts payable

5,000

Cash

5,000

Check No. 3 1/24

Cash

6,000

Accounts receivable

6,000

Deposit No. 2 1/29

Accounts payable

10,000

Cash

10,000

Check No. 4 1/31

Cash Accounts receivable Deposit No. 3

7,000 7,000

265

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EXHIBIT 6-4 Ruiz Company Bank Reconciliation, January 31, 20X2 Balance per books (also called balance per check register, register balance)

$ 8,000

Deduct: Bank service charges for January not recorded on the books (also include any other charges by the bank not yet deducted)*

20

Adjusted (corrected) balance per books

$ 7,980

Balance per bank (also called bank statement balance, statement balance)

$10,980

Add: Deposits not recorded by bank (also called unrecorded deposits, deposits in transit), deposit of 1/31 Subtotal

7,000 $17,980 10,000

Deduct: Outstanding checks, check of 1/29

$ 7,980

Adjusted (corrected) balance per bank *

Note that new entries on the depositor's books are required for all previously unrecorded additions and deductions made to achieve the adjusted balance per books.

This popular reconciliation format has two major sections. The first section begins with the balance in the company’s books, that is, the balance in the Cash T-account. The accountant then makes adjustments for items not entered on the books but already entered by the bank. An example is the $20 service charge. The accountant records these adjustments in the records of the company, in this case deducting the $20 service charge. The second section begins with the balance reported by the bank. Adjustments are made for items entered in the company’s books but not yet entered by the bank. These items normally adjust automatically as deposits and checks reach the bank for processing. After adjustments, each section should end with identical adjusted cash balances. This is the amount that should appear as Cash in Bank on the depositor’s balance sheet. Ruiz Company must also use a journal entry to record any entries made in the bank’s books that also belong in the books of Ruiz. The bank reconciliation indicates that Ruiz must enter the bank service charge in its books: Jan. 31

Bank service charge expense . . . . . . . . . . . . . . . . Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . To record bank charges for printing checks

20 20

Accounting Vocabulary accounting controls, p. 260 accounts receivable turnover, p. 256 administrative controls, p. 259 aging of accounts receivable method, p. 254 allowance for bad debts, p. 250 allowance for doubtful accounts, p. 250 allowance for uncollectible accounts, p. 250 allowance method, p. 250 audit committee, p. 263 average collection period, p. 257

bad debt expense, p. 248 bad debt recoveries, p. 250 bad debts, p. 248 cash discounts, p. 244 compensating balances, p. 258 completed contract method, p. 242 days to collect accounts receivable, p. 257 direct write-off method, p. 249 gross sales, p. 242 internal control systems, p. 259 internal controls, p. 259 net sales, p. 242

percentage of accounts receivable method, p. 253 percentage of completion method, p. 241 percentage of sales method, p. 253 purchase allowance, p. 242 purchase returns, p. 242 reconcile a bank statement, p. 259 sales allowance, p. 242 sales returns, p. 242 specific write-off method, p. 249 trade discounts, p. 243 uncollectible accounts, p. 248

ASSIGNMENT MATERIAL

Assignment Material Questions 6-1 What is the two-pronged test for revenue recognition under current U.S. GAAP? 6-2 Describe the timing of revenue recognition under current U.S. GAAP for a defense contractor in the United States on a $50 million long-term government contract with work spread evenly over 5 years. 6-3 The proposed joint FASB/IASB standard on revenue recognition has a five-step process for revenue recognition. What are the five steps? 6-4 What will be the major effects on revenue recognition if the proposed joint FASB/IASB standard is adopted? 6-5 Why is measuring revenue for a noncash sale more complex than it is for a cash sale? 6-6 Why is the realizable value of a credit sale often less than that of a cash sale? 6-7 Distinguish between a sales return and a sales allowance. 6-8 Distinguish between a trade discount and a cash discount. 6-9 “Trade discounts should not be recorded by the accountant.” Do you agree? Explain. 6-10 “Retailers who accept VISA or MasterCard are foolish because they do not receive the full price for merchandise they sell.” Comment. 6-11 Describe the difference between the gross and net methods of accounting for cash discounts. 6-12 What is the cost-benefit relationship in deciding whether to offer credit to customers, and whether to accept bank credit cards? 6-13 Distinguish between the allowance method and the specific write-off method for bad debts. 6-14 “The Allowance for Uncollectible Accounts account has no subsidiary ledger, but the Accounts Receivable account does.” Explain. 6-15 “Under the allowance method, there are three popular ways to estimate the bad debt expense for a particular year.” Name the three. 6-16 What is meant by “aging of accounts”? 6-17 Distinguish between the percentage of sales approach to applying the allowance method and the aging of accounts receivable approach.

6-18 Explain why a write-off of a bad debt should be reversed if collection occurs at a later date. 6-19 Granting credit has two major impacts on a company, one good and one bad. Describe both. 6-20 What is the relationship between the average collection period and the accounts receivable turnover? 6-21 Describe and give two examples of cash equivalents. 6-22 “A compensating balance essentially increases the interest rate on money borrowed.” Explain. 6-23 “Cash is only 3% of our total assets. Therefore, we should not waste time designing systems to manage cash. We should use our time on matters that have a better chance of affecting our profits.” Do you agree? Explain. 6-24 It is common in sub shops and pizza parlors around the Baruch College campus to find signs that say “Your purchase is free if the clerk does not give you a receipt” or “Two free lunches if your receipt has a red star.” What is management trying to accomplish with these free offers? 6-25 “The cash balance on a company’s books should always equal the cash balance shown by its bank.” Do you agree? Explain. 6-26 List five internal control procedures used to safeguard cash. 6-27 “If everyone were honest, there would be no need for internal controls to safeguard cash.” Do you agree? Explain. 6-28 Distinguish between internal accounting control and internal administrative control. 6-29 “The primary responsibility for internal controls rests with the outside auditors.” Do you agree? Explain. 6-30 What is the primary responsibility of the audit committee? 6-31 Prepare a checklist of important factors to consider in judging an internal control system. 6-32 “The most important element of successful control is personnel.” Explain. 6-33 What is the essential idea of separation of duties? 6-34 Study Appendix 6. When a company makes a bank deposit, it debits its cash account. Why might a bank say the company’s account was “credited”?

267

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Critical Thinking Questions  OBJECT IVE 1

6-35 Revenue Recognition A newly created weekly free newspaper has approached your bank seeking a loan. Although the newspaper is free, it gets significant revenue from advertising. In the first 2 months of operations, it reported profits of $10,000. It has receivables of $70,000 on $200,000 of advertising revenue. Some of the revenue reported for these 2 months included special promotional pricing that gave advertisers 4 months of ads for the price of 2 months. All this promotional revenue was included in the income statement for 2 months. Comment on the reported profit.

 OBJECT IVE 2

6-36 Bank Credit Cards If a company accepts bank credit cards, why might it accept specific cards instead of all of them? For example, some retailers accept VISA and MasterCard, but not American Express or Diner’s Club, while the exact opposite is true for some restaurants.

 OBJECT IVE 1

6-37 Criteria for Revenue Recognition We generally treat revenue as earned when the company delivers merchandise to the customer. At that moment, what additional uncertainty remains about the proper amount of revenue that will ultimately be realized? Would this change under the new revenue recognition criteria under consideration?

 OBJECTIVE 1

6-38 Revenue Recognition and Evaluation of Sales Staff Revenue on an accrual-accounting basis is usually recognized as it is earned. Revenue in cash-basis accounting must be received in cash. Is accrual-basis or cash-basis recognition of revenue more relevant for evaluating the performance of a company’s sales staff? Why?

Exercises  OBJECT IVE 1

6-39 Revenue Recognition Sierra Logging Company hired Reid Construction Company to build a new bridge across the Brown Trout River. The bridge would extend a logging road into a new stand of timber. The contract called for a payment of $12 million on completion of the bridge. Work was begun in 20X0 and completed in 20X2. Total costs were as follows: 20X0 20X1 20X2 Total

$ 2 million 3 million 5 million $10 million

1. Suppose the accountant for Reid Construction Company judged that Sierra Logging might not be able to pay the $12 million. a. How much revenue would you recognize each year under current revenue-recognition standards? b. How much revenue would you recognize each year under the proposed revenue-recognition standards? 2. Suppose Sierra Logging is a subsidiary of a major wood products company. Therefore, receipt of payment on the contract is reasonably certain. How much revenue would you recognize each year under current revenue-recognition standards?

 OBJECT IVE 2

 OBJECT IVE 2

6-40 Noncash Sales Suppose Accenture sold software with a retail value of $240,000 to Atlanta Pictures, Inc. Instead of receiving cash, Accenture received 22,000 shares of Atlanta Pictures stock, which at the time was selling for $10 per share. What revenue should Accenture recognize on the sale? Prepare the journal entry for this sale. 6-41 Net Revenue and Noncash Sales—Auto Dealership Northend Motors sold a new BMW to Salvador Frezatti. The list price of the new car was $40,000. Mr. Frezatti traded in a 5-year old Audi that has a Blue Book value of $15,000. Northend also offered a 10% trade discount off the list price. So Mr. Frezatti paid cash of $21,000. After getting home, Mr. Frezatti discovered that the BMW had a scratch in the passenger-side door, and Northend offered an allowance of $1,000 to cover the repair.

ASSIGNMENT MATERIAL

269

Prepare a schedule showing both the gross revenue and the net revenue for Northend Motors from this transaction. 6-42 Revenue Recognition, Cash Discounts, and Returns Royalton Bookstore ordered 1,000 copies of an introductory physics textbook from Prentice Hall on July 17, 20X0. The books were delivered on August 12, at which time a bill was sent requesting payment of $90 per book. However, a 2% discount was allowed if Prentice Hall received payment by September 12. Royalton Bookstore sent the proper payment, which was received by Prentice Hall on September 10. On December 18, Royalton Bookstore returned 60 books to Prentice Hall for a full cash refund.

 OBJECTIVES 1, 2

1. Prepare the journal entries (if any) for Prentice Hall on (a) July 17, (b) August 12, (c) September 10, and (d) December 18. Include appropriate explanations. Assume that Prentice Hall uses the gross method for cash discounts. 2. Suppose this was the only sales transaction in 20X0. Prepare the revenue section of Prentice Hall’s income statement. 6-43 Sales Returns and Discounts Fresno Fruit Wholesalers had gross sales of $850,000 on credit during the month of March. Sales returns and allowances were $50,000. Cash discounts granted were $35,000 and were accounted for using the gross method. Prepare an analysis of the impact of these transactions on the balance sheet equation. Also show the journal entries. Prepare a detailed presentation of the revenue section of the income statement. Assume the appropriate amount of receivables was collected.

 OBJECTIVE 2

6-44 Gross and Net Methods for Cash Discounts Midvale Manufacturing, Incorporated, reported the following in 20X0 ($ in thousands):

OBJECTIVE 2

Sales Cash discounts on sales

$680 20

1. Assume that Midvale uses the gross method of accounting for cash discounts. a. Prepare the revenue section of the 20X0 income statement. b. Prepare journal entries for the initial revenue recognition for 20X0 sales and the collection of accounts receivable. Assume that all sales were on credit and all accounts receivable for 20X0 sales were collected in 20X0. Omit explanations. 2. Assume that Midvale uses the net method of accounting for cash discounts. a. Prepare the revenue section of the 20X0 income statement. b. Prepare journal entries for the initial revenue recognition for 20X0 sales and the collection of accounts receivable. Assume that all sales were on credit and all accounts receivable for 20X0 sales were collected in 20X0. Omit explanations. c. Suppose the customers passed up the $20,000 cash discounts and paid the full $680,000. Prepare the journal entry for the collection of the accounts receivable. 6-45 Cash Discounts Transactions Grodahl Electronics is a wholesaler that sells on terms of 2/10, n/30. Suppose it sold video equipment to Costco for $600,000 on open account on January 10. Payment (net of cash discount) was received on January 19. By using the balance sheet equation framework, analyze the two transactions for Grodahl Electronics using the gross method for cash discounts. Also prepare journal entries. 6-46 Entries for Cash Discounts and Returns on Sales The Walla Walla Wine Company, a wholesaler of Washington state wines, sells on credit terms of 2/10, n/30. It uses the gross method for cash discounts. Consider the following transactions: June 9 June 11 June 18 June 26 July 10 July 12

Sales on credit to Westlake Wine Mercantile, $40,000. Sales on credit to Marty’s Liquors, $15,000. Collected from Westlake Wine Mercantile. Accepted the return of six cases from Marty’s Liquors, $1,000. Collected from Marty’s Liquors. Westlake Wine Mercantile returned some defective wine that it had acquired on June 9 for $100. Walla Walla issued a cash refund immediately.

 OBJECTIVE 2

 OBJECTIVE 2

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CHAPTER 6 • ACCOUNTING FOR SALES

Prepare journal entries for these transactions. Omit explanations. Assume the full appropriate amounts were exchanged.

OBJECTIVE 2

6-47 Credit Terms, Discounts, and Annual Interest Rates As the struggling owner of a new restaurant, you suffer from a habitual shortage of cash. Yesterday the following invoices arrived: Vender

Face Amount

Hong Fruit & Vegetables Rose Exterminators Iowa Meat Supply John’s Fisheries Garcia Equipment

$ 700 90 850 1,000 2,000

Terms n/30 EOM 15, EOM 1/10, n/30 2/10, n/30

1. Write out the exact meaning of each of the terms. 2. You can borrow cash from the local bank on a 10-, 20-, or 30-day note bearing an annual interest rate of 14%. Should you borrow to take advantage of the cash discounts offered by the last two vendors? Why? Show computations. For interest rate computations, assume a 360-day year.

 OBJECT IVE 2

6-48 Accounting for Credit Cards Michelle’s Classic Clothing Store has extended credit to customers on open account. Its average experience for each of the past 3 years has been as follows:

Sales Bad debt expense Administrative expense

Cash

Credit

Total

$500,000 — —

$300,000 5,000 8,000

$800,000 5,000 8,000

Michelle Lebeck is considering whether to accept bank cards (for example, VISA or MasterCard). She has resisted because she does not want to bear the cost of the service, which would be 4% of gross sales. The representative of VISA claims that the availability of bank cards would have increased overall sales by at least 10%. Regardless of the level of sales, the new mix of the sales would be 50% bank card and 50% cash. 1. How would a bank card sale of $300 affect the accounting equation? Where would the discount appear on the income statement? 2. Should Lebeck adopt the bank card if sales do not increase? Base your answer solely on the sparse facts given here. 3. Repeat requirement 2, but assume that total sales would increase 10%.

 OBJECT IVE 2

6-49 Trade-ins Versus Discounts Many states base their sales tax on gross sales less any discount. Trade-in allowances are not discounts, so companies cannot deduct them from the sales price for sales tax purposes. Suppose Jit Eap had decided to trade in his old car for a new one with a list price of $32,000. He will pay cash of $20,000 plus sales tax. If he had not traded in a car, the dealer would have offered a discount of 15% of the list price. The sales tax is 7%. How much of the $12,000 price reduction should be called a discount? How much a tradein? Mr. Eap wants to pay as little sales tax as legally possible.

 OBJECT IVE 3

6-50 Uncollectible Accounts During 20X1, the Downtown Department Store had credit sales of $900,000. The store manager expects that 2% of the credit sales will never be collected, although no accounts are written off until 10 assorted steps have been taken to attain collection. The 10 steps require a minimum of 14 months.

ASSIGNMENT MATERIAL

Assume that during 20X2, specific customers are identified who are never expected to pay $16,000 that they owe from the sales of 20X1. All 10 collection steps have been completed. 1. Show the impact on the balance sheet equation of the preceding transactions in 20X1 and 20X2 under (a) the specific write-off method, and (b) the allowance method. Which method do you prefer? Why? 2. Prepare journal entries for both methods. Omit explanations. 6-51 Specific Write-off Versus Allowance Methods The Empire District Electric Company serves customers in the region where the states of Kansas, Missouri, Arkansas, and Oklahoma come together. Empire District uses the allowance method for recognizing uncollectible accounts. The company’s January 1, 2012, balance sheet showed accounts receivable of $42,296,000, which was shown net of uncollectible accounts of $1,138,000.

 OBJECTIVE 3

1. Suppose Empire District wrote off a specific uncollectible account for $30,000 on January 2, 2012. Assume this was the only transaction affecting the accounts receivable or allowance accounts on that day. Give the journal entry to record this write-off. What would the balance sheet show for accounts receivable at the end of the day on January 2. 2. Suppose Empire District used the specific write-off method instead of the allowance method for recognizing uncollectible accounts. Give the journal entry to record this write-off. Compute the accounts receivable balance that would be shown on the January 2, 2012, balance sheet. 6-52 Allowance Method and Correcting Entries The Good Samaritan Hospital uses the allowance method in accounting for bad debts. A journal entry was made for writing off the accounts of Jane Peterson, Eunice Belmont, and Samuel Goldman. Do you agree with this entry? If not, show the correct entry and the correcting entry. Bad debt expense . . . . . . . . . . . . . . . . . . . . . . Accounts receivable . . . . . . . . . . . . . . . . .

 OBJECTIVE 3

16,205 16,205

6-53 Bad Debts Prepare all journal entries for 20X2 concerning the following data for a medical clinic that performs elective laser surgery that corrects vision. Such procedures are not covered by third-party payers such as Blue Cross or Medicare. Consider the following balances of the medical clinic on December 31, 20X1: Gross Receivables from Individual Patients, $250,000 and Allowance for Doubtful Receivables, $50,000, which makes Net Receivables $200,000. During 20X2, total billings to individual patients were $2.5 million. Past experience indicated that 10% of such individual billings would ultimately be uncollectible. Write-offs of receivables during 20X2 were $240,000.

 OBJECTIVE 3

6-54 Bad Debt Allowance Kansas Furniture Mart had sales of $1,150,000 during 20X1, including $600,000 of sales on credit. Balances on December 31, 20X0, were Accounts Receivable, $120,000, and Allowance for Bad Debts, $10,000. For 20X1 collections of accounts receivable were $560,000. Bad debt expense was estimated at 2% of credit sales, as in previous years. Write-offs of bad debts during 20X1 were $9,000.

 OBJECTIVE 3

1. Prepare journal entries concerning the preceding information for 20X1. 2. Show the ending balances of the balance sheet accounts on December 31, 20X1. 3. Based on the given data, would you advise Eleanor Sarkowski, the president of the store, that the 2% estimated bad debt rate appears adequate? 6-55 Bad Debt Recoveries Southcenter Variety Store has many accounts receivable. The Southcenter balance sheet, December 31, 20X1, showed Accounts Receivable, $950,000, and Allowance for Uncollectible Accounts, $40,000. In early 20X2, write-offs of customer accounts of $31,000 were made. In late 20X2, a customer, whose $10,000 debt had been written off earlier, won a $1 million sweepstakes cash prize. The buyer immediately remitted $10,000 to Southcenter. The store welcomed the purchaser’s money and return to high credit standing. Prepare the journal entries for the $31,000 write-off in early 20X2 and the $10,000 receipt in late 20X2.

 OBJECTIVE 3

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 OBJECT IVE 3

6-56 Subsidiary Ledger A custom furniture company made credit sales of $840,000 in 20X1 to 100 customers: Ferrara, $5,000; Cerruti, $7,000; others, $828,000. Total collections during 20X1 were $760,000 including $5,000 from Cerruti, but nothing was collected from Ferrara. At the end of 20X1, an allowance for uncollectible accounts was provided of 2.5% of credit sales. 20X1 is the company’s first year of operations. 1. Set up general ledger accounts for Accounts Receivable, Allowance for Uncollectible Accounts, and Bad Debt Expense plus a subsidiary ledger for Accounts Receivable. The subsidiary ledger should consist of two individual accounts plus a third account called Others. Post the entries for 20X1. Prepare a statement of the ending balances of the individual accounts receivable to show that they reconcile with the general ledger account. 2. On March 24, 20X2, the Ferrara account was written off. Give the journal entry.

 OBJECT IVE 4

6-57 Accounts Receivable Turnover and Average Collection Period Vulcan Materials Company, the nation’s largest producer of construction aggregates, is headquartered in Birmingham, Alabama. The company had 2011 sales of $2,565 million. Beginning and ending net accounts receivable as of December 31, 2010 and 2011 were $261 million and $299 million, respectively. Compute Vulcan’s accounts receivable turnover and average collection period for the fiscal year. Assume all sales are on open account.

 OBJECT IVE 4

6-58 Accounts Receivable Ratios Bayer Group, the German chemical and pharmaceutical company, is the third largest pharmaceutical company in the world. It had the following results in 2009–2011 (in millions of euros):

Sales Ending accounts receivable

2009

2010

2011

€31,168 € 6,106

€35,088 € 6,668

€36,528 € 7,061

Compute the accounts receivable turnover and the average collection period for 2010 and 2011. Did Bayer’s ratios improve or decline in 2011 compared with 2010? Assume all sales are on credit.

 OBJECT IVE 5

6-59 Compensating Balances Morneau Company borrowed $200,000 from Citibank at 8% interest. The loan agreement stated that a compensating balance of $25,000 must be kept in the Morneau checking account at Citibank. The total Morneau cash balance at the end of the year was $45,000. 1. How much usable cash did Morneau Company receive for its $200,000 loan? 2. What was the real interest rate paid by Morneau? 3. Prepare a footnote for the annual report of Morneau Company explaining the compensating balance.

 OBJECT IVE 6

6-60 Internal Control Weaknesses Identify the internal control weaknesses in each of the following situations, and indicate what change or changes you would recommend to eliminate the weaknesses: 1. The internal audit staff of Wichita Aerospace, Inc., reports to the controller. The company conducts internal audits only when a department manager requests one, and audit reports are confidential documents prepared exclusively for the manager. The company does not allow internal auditors to talk to the external auditors. 2. Liz Paltrow, president of Southwestern State Bank, a small-town Wyoming bank, wants to expand the size of her bank. She hired Fred Gladstone to begin a foreign loan department. Gladstone had previously worked in the international department of a London bank. Paltrow told him to consult with her on any large loans, but she never specified exactly what was meant by “large.” At the end of Gladstone’s first year, Paltrow was surprised and pleased by Gladstone’s results. Although he had made several loans larger than any made by other

ASSIGNMENT MATERIAL

sections of the bank and had not consulted with her on any of them, Paltrow hesitated to say anything because the financial results were so good. She certainly did not want to upset the person most responsible for the bank’s excellent growth in earnings. 3. Isabelle Reed is in charge of purchasing and receiving watches for Import Jewelry, Inc., a chain of jewelry stores. Reed places orders, fills out receiving documents when the watches are delivered, and authorizes payment to suppliers. According to Import Jewelry’s procedures manual, Reed’s activities should be reviewed by a purchasing supervisor. However, to save money, the supervisor was not replaced when she resigned 3 years ago. No one seems to miss the supervisor. 6-61 Assignment of Duties Fleetfoot Wholesalers is a distributor of several popular lines of sports and leisure shoes. It purchases merchandise from several suppliers and sells to hundreds of retail stores. Here is a partial list of the company’s necessary office routines:

 OBJECTIVE 6

1. Verifying and comparing related purchase documents: purchase orders, purchase invoices, receiving reports, etc. 2. Preparing vouchers for cash disbursements and attaching supporting purchase documents 3. Signing vouchers to authorize payment (after examining vouchers with attached documents) 4. Preparing checks to pay for the purchases 5. Signing checks (after examining voucher authorization and supporting documents) 6. Mailing checks 7. Daily sorting of incoming mail into items that contain money and items that do not 8. Distributing the mail: money to cashier, reports of money received to accounting department, and remainder to various appropriate offices 9. Making daily bank deposits 10. Reconciling monthly bank statements The company’s chief financial officer has decided that no more than five people will handle all these routines, including himself as necessary. Prepare a chart to show how these operations could be assigned to the five employees, including the chief financial officer. Use a row for each of the numbered routines and a column for each employee: Financial Officer, A, B, C, D. Place a check mark for each row in one or more of the columns. Observe the rules of the textbook checklist for internal control, especially separation of duties. 6-62 Simple Bank Reconciliation Study Appendix 6. East End Hospital has a bank account. Consider the following information:

 OBJECTIVE 7

a. Balances as of July 31: per books, $50,000; per bank statement, $35,860. b. Cash receipts of July 31 amounting to $9,000 were recorded and then deposited in the bank’s night depository. The bank did not include this deposit on its July statement. c. The bank statement included service charges of $140. d. Patients had given the hospital some bad checks amounting to $11,000. The bank marked them NSF and returned them with the bank statement after charging the hospital for the $11,000. The hospital had made no entry for the return of these checks. e. The hospital’s outstanding checks amounted to $6,000. Required 1. Prepare a bank reconciliation as of July 31. 2. Prepare the hospital journal entries required by the given information.

Problems 6-63 Revenue Recognition on Long-term Contracts On January 2, 20X0, Kowalski Construction Company signed a contract to provide paved roads to a new housing development. The project will last 2 years, and the total payment will be $4 million, to be paid at completion of the project. Kowalski’s budgeted cost for the project is $3  million. Work will progress evenly over the 2 years. On December 31, 20X0, Kowalski’s

 OBJECTIVE 1

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accountant asks you what revenue should be recorded for 20X0. Costs of $1.5 million were incurred during 20X0. 1. Suppose Kowalski uses the percentage of completion method. What revenue should be recorded for 20X0? What profit is recognized in 20X0? 2. Suppose Kowalski uses the completed contract method. What revenue should be recorded for 20X0? What profit is recognized in 20X0? 3. Assume that the contract was with a large corporation that is very stable. Under current U.S. GAAP, which method should Kowalski use? 4. Assume that the contract is with a small developer and the economy has taken a downturn during 20X0, making payment of the final contract price highly uncertain. However, Kowalski Company still believes it will receive payment and continues working on the project. Under current U.S. GAAP, which method should Kowalski use? 5. How would your answers to requirement 4 change if Kowalski were reporting under IFRS rather than U.S. GAAP?

 OBJECT IVE 2

6-64 Bank Cards VISA and MasterCard are used to pay for a large percentage of retail purchases. The financial arrangements are similar for both bank cards. A news story provided the following example. Assume that a cardholder charges $500 for a dress to her VISA card. The merchant would then deposit the sales draft with its bank, which immediately credits $500 less a small transaction fee (say 4% of the sale) to the merchant’s account. The bank that issued the customer her card then pays the merchant’s bank $500 less a 3% transaction fee, allowing the merchant’s bank a 1% profit on the transaction. 1. Prepare the journal entry for the sale by the merchant. 2. Prepare the journal entries for the merchant’s bank concerning (a) the merchant’s deposit, and (b) the collection from the customer’s bank that issued the card. 3. Prepare the journal entry for the customer’s bank that issued the card. 4. The national losses from bad debts for bank cards have recently been about 5% of the total billings to cardholders. If so, how can the banks justify providing this service if their revenue from processing is typically 3%–4%?

 OBJECTIVE 2

6-65 Sales Returns and Allowances Crown Crafts, Inc., produces children’s products such as infant and toddler bedding, bibs, soft goods, and accessories. Major customers include Wal-Mart and Target. A footnote to the company’s 2011 financial statements states that it records sales when goods are shipped to customers, and these sales are reported net of allowances for estimated returns and allowances. The first line of Crown Crafts’ income statement was (in thousands) “Net sales … $89,971.” 1. Suppose customer returns in 2011 were 2.5% of gross sales and sales allowances were 1.5% of gross sales. Assume that the company also gave customers cash discounts of $1,240,000. Compute the amount of gross sales. Assume the gross method for accounting for cash discounts. Round to the nearest thousand. 2. Crown Crafts had only one line for net sales on its income statement. Prepare a more detailed presentation of sales, beginning with gross sales and ending with net sales.

 OBJECT IVE 2

6-66 Gross and Net Methods for Cash Discounts Belkin Company offers a cash discount of 2% if payment is received within 15 days, with full payment due in 30 days. Belkin sold some merchandise to Alvarez Company for $10,000 on June 1. 1. Suppose that on June 14, Alvarez Company paid the appropriate amount to Belkin. a. Prepare Belkin Company’s journal entries on June 1 and June 14 assuming that Belkin used the gross method to account for cash discounts. b. Prepare Belkin Company’s journal entries on June 1 and June 14 assuming that Belkin used the net method to account for cash discounts. 2. Suppose instead, that on June 30 Alvarez Company paid the appropriate amount to Belkin. a. Prepare Belkin Company’s journal entries on June 1 and June 30 assuming that Belkin used the gross method to account for cash discounts. b. Prepare Belkin Company’s journal entries on June 1 and June 30 assuming that Belkin used the net method to account for cash discounts.

ASSIGNMENT MATERIAL

6-67 Allowance for Credit Losses Tompkins Financial Co